AN EXPLORATION OF TOOLS OF ANALYSIS COMMONLY USED
BY PRIVATE EQUITY IN MAKING INVESTMENT DECISION
By
STEVE ARMAND BOYOM KOUOGANG
LSC STUDENT NUMBER:
L0938FKFK0210
UWIC STUDENT
NUMBER: 10008097
Presented as part of the requirement for the award of MBA at
University of Wales Institute Cardiff (UWIC)
September 2011
The concept of investing behaviour regarded as a probable
cause of the decline in the number of investment activities of venture capital
over the last three years constitutes the background of this dissertation. Its
aims are to investigate the classic tools of analysis, which could be found in
the financial literature, when it comes to make investment decision. Another
objective is to determine the applicable technique of evaluating flexible and
reversible start-ups' investment proposals. The third aim consists of
conducting a survey of venture capital analysts to find out their practice by
way of capital budgeting for start-ups. The fourth is to suggest beneficial
solutions to both parties involved in making such an investment decision, that
is to say private equity analyst and start-up company. The research questions
are: what are the classic methods capable of helping venture capitalist to make
investment decision devoid of any flexibility with regard to start-up
companies? In case the newly created firm's project gets some flexible and
reversible aspects, how should the venture capitalist make investment decision?
What can we learn from an inquiry into the practice of venture capitalist in
the field of determining the investment decision for newly created companies?
Are the findings from the investigation into the way the venture capitalists
make investment decision in practice profitable to both the main players,
namely venture capital firms and new entrepreneurs? Both discounted and
non-discounted cash flow methods are usable classic methods for appraising
newly created firms' capital expenditure. Moreover, in making flexible
investment decision for start-ups, real options turn out to be suitable.
Furthermore, it emerged from data collected with the help of an electronic
questionnaire and analysed in accordance with the qualitative philosophy of
research that 50 percent of private equity firms were more attracted by
investing in Health care. Concerning the techniques used by venture capital
analysts in making start up organisations' non-flexible capital budgeting
decision devoid of any flexibility, we noticed that a third of those analysts
said referring to NPV. Conversely, the revelation appeared to be that private
equity analysts did make a sweep clean of the IRR technique in this respect.
Thirdly, by way of making flexible capital budgeting decision for start up
organisations, the NPV method was in the lead with 37.5% of use when real
options only scored 12.5%.
We would like to extend our warmest thanks to all those people
and firms whose reviews and suggestions contribute to the achievement of this
dissertation.
CHAPTER I
INTRODUCTION...................................................................................
5
CHAPTER II LITERATURE REVIEW
....................................................................8
CHAPTER III RESEARCH METHODOLOGY
......................................................21
CHAPTER IV FINDINGS AND DATA ANALYSIS
...............................................31
CHAPTER V CONCLUSION AND RECOMMENDATIONS
...............................51
BIBILOGRAPHY..................................................................................................59
APPENDIX
.............................................................................................................
.....63
1.1 RESEARCH CONTEXT
There are a number of venture capitalists whose aims are to
provide capital to ventures, which failed to obtain funds from the conventional
sources such as banks as suggested by Wright and Robbie (1998).This does not
mean that nothing could be easier than being funded by venture capitalists for
start-up companies. In fact, in accordance with the British Venture Capital
Association (BVCA), «Private Equity and Venture Capital
firms invested £7.5 billion globally in 2009, compared to £19.5bn
invested in 2008 and £31.6bn in 2007. In 2009, 987 companies received
private equity or venture capital backing, in contrast to 1,672 in 2008 and
1,680 in 2007» (Private Equity and Venture Capital Report on
Investment Activity, 2009).
Clearly, the above figures suggest investment activities of
venture capitals have declined significantly reaching a half comparing with
what they were 3 years ago. To what could this drop attribute? Broadly
speaking, some (such as «2009 Fidelity Investments Couples Retirement
Study, Executive Summary» cited by Roszkowski and Davey, 2010, p.
42-43) have put all the blame on the 2008 global economy collapse. Whereas,
other have pointed out the notion of risk, especially the concepts of
«risk tolerance» and «risk perception» arguing that both
of those risks determine investing behaviour (Roszkowski and Davey, 2010, p.
43). The topic of this research rests on this background. Having said that,
what are the objectives of this dissertation?
1.2 RESEARCH OBJECTIVES
The purpose of this investigation is to examine the various
tools, which could be considered in a particular way when it comes to make
investment decisions for new ventures. Because we are, to some extent, in
favour of the second argument mentioned in the end of the previous section, we
will further explore the different methods, whether based on the theory and /
or practical point of view, and used by venture capitals to grant funds to
start-up companies. Indeed, our objectives are:
1. To carry out a meticulous breakdown of the traditional
tools, which could be used to determine what real assets of a newly created
firm the venture capitalist should invest in.
2. To find out which method can be applicable when the
start-up organisation's project in question is to some extent flexible and
reversible.
3. To survey some venture capital firms in order to catch on
what techniques they use in practice to analyse investment project of start-up
industries.
4. And to recommend solutions based on my research, which will
help venture capitalists as well as fresh entrepreneurs to identify what
criteria could be much more suitable to distinguish fruitful ventures from
unsuccessful projects.
The aforesaid purposes required some research questions that
will be explored.
1.3 RESEARCH QUESTIONS
In order to attain the above set objectives, the following
questions are raised:
1. What are the classic methods capable of helping venture
capitalist to make investment decision devoid of any flexibility with regard to
start-up companies?
2. In case the newly created firm's project gets some flexible
and reversible aspects, how should the venture capitalist make investment
decision?
3. What can we learn from an inquiry into the practice of
venture capitalist in the field of determining the investment decision for
newly created companies?
4. Are the findings from the investigation into the way the
venture capitalists make investment decision in practice profitable to both the
main players, namely venture capital firms and new entrepreneurs?
In any case, we should now turn to know more about the answers
from the scientific writings on this topic in chapter 2.
Moreover, chapter 3 constitutes the research methodology while
chapters 4 and 5 are respectively devoted to
data analysis and findings, and conclusion and recommendations.
CHAPTER II LITERATURE REVIEW
|
The purpose of this chapter consists in shedding more light
on the relevant scientific writings referring to the methods ordinarily used by
private equity finance when it comes to make investment decision for start-up
companies. Boosted by what precedes, it would be methodical to define any key
concept of this topic. For that aim, a deductive reasoning will be employed;
therefore this work will by turns scrutinize the concepts of «private
equity» first, «investment decision» secondly and
a wide range of «tools» that allow private equity to determine what
real assets need to be invested in finally. This literature review will then
ended with the bare bones of the main points raised.
2.1 THE CONCEPT OF PRIVATE EQUITY
The roots of «private equity», with regard to the
attention the academic community paid to that term at least, can be stretched
far back into the 80s as argued by Wright and Robbie (1998). In any case, the
notion of «private equity» has recently been devised in a broad sense
as «[involving] investment in unquoted companies, [and it includes] both
early stage venture capital, and later stage buyouts» (Wood and Wright,
2009, p. 361).
This conception of the term «Private equity» echoes
that of Brealey, Myers and Allen (2008). Indeed, according to these authors the
notion of private equity could be defined as «equity that is not publicly
traded and that is used to finance business start-ups, leveraged buyouts,
etc.» (Brealey, Myers and Allen, 2008, p. G-10).
Clearly, from the above definitions there is a convergence on
the broad understanding of «private equity» because of its features,
namely money invested in venture and not listed companies. Moreover, this
conception has been adopted in practice. In fact, the British Venture Capital
Association (2010) states «the term private equity is
generally used in Europe to cover the industry as a whole, including both
buyouts and venture capital» (BVCA, 2010, p. 14).
However, the BVCA itself carries on drawing the difference between private
equity and Venture capital. The former «describes equity investments in
unquoted companies, often accompanied by the provision of loans and other
capital bearing an equity-type risk». The latter, however, constitutes a
«subcategory covering the start-up to expansion stages of investment»
(BVCA, 2010, p. 14).
With regard to the concept of start-up, Arnold (2004)
suggested a definition in 2004. In his opinion, a start-up company or
«startup» is a
company with a limited or
non-existing operating history (Arnold, 2004, p. 388). These companies,
generally newly created, are in a phase of
development and
research for
markets. The term became
popular internationally during the
dot-com bubble
covering roughly 1995-2000 when numerous
dot-com
organisations were created (
http://en.wikipedia.org/wiki/Dot-com_bubble).
At any rate, throughout this paper private equity will be
perceived in a broad sense. This is due to the fact that the focus here are the
techniques used to carry out investment appraisal for start up companies. The
term «private equity», under this consideration, will therefore
allude to «venture capital». We should now turn to scrutinise how the
scientific writings consider the concept of «investment decision»
2.2 THE NOTION OF INVESTMENT DECISION
To start with, it should be appropriate to comprehend the
concept of investment decision by examining the scientific writings on
«investment» and «investment decision» successively.
2.2.1 Investment
Generally speaking, «investment» means the use of
money in the hope of
making more money. (www.encarta.msn.com/encnet/dictionary/dictionaryhome.aspx).
More specifically in finance, the concept of
INVESTMENT refers to the
purchase of a
financial
product or other
item of
value with an
expectation of favourable future returns. (
http://www.investorwords.com/2599/investment.html#ixzz1KcRjbPHc).
Two authors, Arnold (2008) and Chandra (2008), further develop
this conception of the term «investment». According to the former
(2008), «investment involves resources being laid aside to produce a
return in the future, for instance, today's consumption is reduced in order to
put resources into building a factory and the creation of machine tools to
produce goods in later years.» (Arnold, 2008, p. 20). In addition, the
latter (2008) conceives investment as «a sacrifice of current money or
other resources for future benefits.» (Chandra, 2008, p. 3). What about
investment decision especially?
2.2.2 Investment decision
As far as corporate finance is concerned, there are two
essential issues that need to be addressed. «First, what real assets
should the firm invest in? Second, how should the cash for the investment be
raised? The answer to the first question is the firm's investment,
or capital budgeting, decision. The answer to the
second is the firm's financing decision» (Brealey, Myers
and Allen, 2008, p. 4). Capital budgeting is also named by scholars
«Capital expenditure -capex-», that is the «selection of
investment projects» (Arnold, 2008, p. 50).
From all what precedes, there is no doubt that the second
decision is by far out of the remit of this research topic. As a result,
venture capitalist should have to find only answers to the first question.
Doing so, the sheer scale of the problem has something to do with the methods
he or she will use for the purpose of investment appraisal. We should now turn
to examine this issue in the light of the relevant academic research.
2.3 FINANCIAL THEORIES ON TECHNIQUES USED BY PRIVATE
EQUITY FOR INVESTMENT APPRAISAL
There has been a wide range of academic writings on private
equity's investment appraisal as a whole. In fact, those writings were
focussing in particular on standards that venture capital firms refer to in
making investment decision. This has been shown by the following authors:
MacMillan, Siegel and Subbanarasimha (1985), MacMillan, Zemann and
Subbanarasimha (1987), and Zacharakis and Meyer (2000). Primarily, the
aforementioned benchmarks are consisted of four components: firstly product
characteristics, secondly market characteristics, thirdly company's financial
position and outlook, and finally the characteristics of the entrepreneur or
management team.
Five years later,
Wright
and Proimos (2005) carried out a pilot study of venture capital investment
appraisal in Australia. They explored both the «investment process and
some of the strategies used by [Venture Capitalists] for reducing selected
risks. The specific source of risk examined [was] information asymmetry, which
is caused by lack of information on the part of the [Venture Capitalists], and
which can lead to the added risks of adverse selection and moral hazard» (
Wright
and Proimos, 2005). Broadly speaking, this work concentrated mainly on the
investment process. In fact, by surveying four Australian venture capital firms
these authors found that those organisations did utilise Berger and Udell's
(1998) three stages of investment model, that is to say selection, contracting
and monitoring.
It has to be pointed out to both
Wright
and Proimos (2005) credits that their paper seems to be a clear and recent
contribution to the understanding of the series of actions taken into
consideration by private equity for making investment decision, albeit it does
not dwell that much upon the methods as such used whilst appraising proposals.
We should therefore move on to the investigation of any tools of investment
evaluation.
With respect to that purpose, financial theories provide
numerous techniques for investment evaluation, for example Net present Value,
Internal rate of return, Payback period, Profitability index, Accounting rate
of return and Real options. The latter, which has come to light in the 80s,
started attracting scholars attention in the 90s as suggested by Borison
(2005, p. 17); thus it is deemed as a recent means of investment appraisal
whereas the five other out of the list could be called classics methods.
2.3.1 Traditional tools of investment assessment
Prior research into traditional tools of investment appraisal
makes out discounted cash flow that can be distinguished from non-discounted
cash flow methods. (
www.swlearning.com/finance/brigham/ifm8e/web_chapters/webchapter28.pdf
, p.28-1;
www.//portal.lsclondon.co.uk/resources/file.php/879/Lec_23/Investment_Appraisal.pdf
, p. 15). This philosophy will be taken up here and further followed under this
section. Be that as it may, the rule of time value of money constitutes the
basis of that distinction as shown for instance by Arnold (2008, p. 50),
Chandra (2008, p. 116) and Vernimmen et al. (2009, p. 289). In fact, these last
authors make use of a metaphorical quote to represent the time value of money
in these terms: «a bird in the hand is worth two in the bush».
Roughly speaking, this prime financial principle suggests for example that a
pound today is more valuable than a pound a year hence. As support for such a
claim, Chandra (2008, p. 116) highlighted two major reasons. Firstly, if
someone makes up his mind to invest his pound now, it can be a source of
positive returns. Secondly, a pound today stands for a more meaningful
purchasing power than a pound a year later than now in case of inflation
especially.
2.3.1.a. Discounted cash flow techniques
As previously mentioned, Net present value (NPV) and Internal
rate of return (IRR) are on focus here.
Concerning the former, previous academic writings have viewed
it as a «project's net contribution to wealth» (Brealey, Myers and
Allen, 2008, p.G-9). According to
Vernimmen
et al., (2009), there is a triple interpretation of the notion of Net present
value. To start with, Net present value refers to «the value created by an
investment - for example, if the investment requires an outlay of €100 and
the present value of its future cash flow is €110, then the investor has
become €10 wealthier.» Moreover, Net present value means «the
maximum additional amount that the investor is willing to pay to make the
investment - if the investor pays up to €10 more, he/she has not
necessarily made a bad deal, as he /she is paying up to €110 for an asset
that is worth 110.» At last, Net present value is also «the
difference between the present values of the investment (€110) and its
market values (€100).» (2009, p. 296).
Relating to Net present values calculations, since the 80s,
there has been a widespread agreement among scholars with regard to the
estimation of cash flows as suggested by the writings of the following authors:
McMahon (1981), Mukherjee (1988), and Patterson (1989).
Even more recently, Brealey, Myers and Allen, (2008, pp.
160-161), Vernimmen P. et al., (2009, p. 296), consider cash flow calculations
in a particular way. Kalyebara and Ahmed (2011, pp. 63-64), further enumerate
10 general principles for doing so. However, these rules could be simplified to
a set of 3 related benchmarks. In the first place, in order to avoid bad
judgment a financial manager should make sure he or she does «discount
cash flows, not profit». In the second place, he or she should ensure the
project's incremental cash flows are assessed, that is «the difference
between the cash flows with the project and those without the project». In
the third place, he or she needs to «treat inflation consistently.»
(Brealey, Myers and Allen, 2008, pp. 160-161). The Chief Finance Officer of a
private equity firm for example should now turn to rank the project properly
speaking.
In order to so, he or she will look at the project Net
Present Value. If this is greater than zero, the proposal will be accepted.
Nonetheless, the project will be rejected on the contrary circumstances. As
generally admitted by the academics, the Net present value rule «measures
the creation or the destruction of value that could result from [...] making
investment [decision]» (Vernimmen et al., 2009, p. 302). Because
maximising the value of shareholders wealth is the core objective of the firms,
a positive net present value means in a simply way that the return of the
selected project goes beyond the investor's expectations. Therefore, there is
to this extent a consensus among academics. In fact, many authors such as
Arnold (2008, p. 56), Vernimmen et al. (2009, p. 296), Droms and Wright (2010,
pp. 193-194) and Kalyebara and Ahmed (2011, p.54) do agree with the idea that
Net present value method constitutes the route that goes to good investment
decision. However, the Net present value seems not to be a «panacea».
As a matter of fact, the Net present value shortcomings have
been pointed out. To begin with, Vernimmen et al., (2009) find that technique
difficult to figure out instinctively and directly. Moreover, Net Present value
does not have a high opinion of «the value of managerial flexibility, in
other words the options that the manager can exploit after an investment has
been made in order to increase its value» (Vernimmen et al., 2009, p.
297). Finally, thanks to its easiness of use, the figure arising from the
Internal Rate of Return attracts more financial managers than that of the Net
Present value tool does. An evidence of the widespread use of The Internal rate
of return can be found in a survey of 4,440 United States organisations
conducted by Graham and Harvey (2001) 10 years ago. Their results showed that
«74.9% [chief finance officers] always or almost always use the internal
rate of return», which was roughly 1% more than those who referred to the
Net present value criterion. (Graham and Harvey, 2001, p. 193).
Relating to the latter discounted cash flow tool, it should
be noted that this method is regarded by the entire academic community
(Brealey, Myers and Allen, 2008, p. 117; Vernimmen et al., 2009, p. 297) as an
earnest challenger of the net present value method. Notwithstanding, what does
the Internal rate of return technique mean?
Droms and Wright (2010, p. 194) suggest that it is the
«discount rate that exactly equates the present value of the expected
benefits from a project to the cost of the project». This conception
echoes with that of Brealey, Myers and Allen (2008). They devise the Internal
rate of return as the «discount rate at which investment has zero net
present value» (Brealey, Myers and Allen, 2008, pp. G-7).
Regarding its calculation, there is also a consensus on the
view that it is found with the help of «trial and error» in a
customary way (Droms and Wright, 2010, p. 194; Brealey, Myers and Allen, 2008,
p.122). In brief, there are three steps in determining the IRR. First, a
financial manager should figure out a NPV (a) at one discount rate (a %); then
he/she should find a second NPV (b) at (b %), and as last in the series,
interpolate, that is find the value of the approximate IRR that lies between
the two NPVs, often by means of graph. The formula could result in this way:
(
http://portal.lsclondon.co.uk/resources/course/view.php?id=871).
Concerning the IRR rule, it simply states that whenever an
investment's rate of return is beyond the investor's minimum acceptable rate of
return on a project, it is accepted (Vernimmen et al., 2009, p. 309; Brealey,
Myers and Allen, 2008, p. 123).
Nevertheless, the IRR criterion can undergo some limits
highlighted by financial literature as well. Thus, Brealey, Myers and Allen
(2008) have pointed out numerous problems with the IRR. Indeed, many internal
rates of return for a project can result from lots of changes in the sign of
cash flows. In addition, in case of proposals that are mutually exclusive, the
IRR can probably give a deformed idea of the projects value. As the final
point, the IRR method does not take into account the relative size of projects.
(
http://portal.lsclondon.co.uk/resources/course/view.php?id=871).
To sum it up, over and above of these methods that take into
account one of the core principle of financial theory relating to the
investment decision making, which is the rule of time value of money, there are
other non-discounted cash flows techniques. These tools are worth a visit
now.
2.3.1. b. Non-Discounted cash flows
criteria
Under this section, will be explored the Payback period, the
Profitability index, and the Book or Accounting rate of return methods.
Concerning the Payback period, it can be conceived as the
length of time within a project repays its initial cost. To Droms and Wright,
(2010) the payback rule simply consists of selecting «any project with the
shortest payback period» (Droms and Wright, 2010, p. 191). However,
according to Brealey, Myers and Allen (2008), two examples of thing can go
wrong with the payback technique. First, it does not encompass «all cash
flow after the cut-off date; [secondly, the] «payback rule gives equal
weight to all cash flows before the cut-off date», (Brealey, Myers and
Allen, 2008, p. 121).
With regard to the profitability index, it essentially
provides an answer to the following concern: «How highest NPV are we
getting per pound invested?» Whenever funds are lacking, only projects
that match the insufficient supply of money should be selected. The formula of
the Profitability index is known as followed:
With respect to the accounting rate of return, it should be
mentioned that it amounts to determining the potential book income «as a
proportion of the book value of the assets that the firm is proposing to
acquire». Its formula can be read as followed:
Accounting or Book rate of return = book income ÷ book
assets (Brealey, Myers and Allen, (2008, p. 119). Because the book rate of
return is a sort of means across the total activities of the organisation, we
should not dwell too much upon it. Indeed, this paper's focus rests on the
methods private equity use for investment decision making for start-up
companies.
In any case, we should now turn to explore the financial
literature on recent methods of investment appraisal.
2.3.2 Recent tools of investment assessment: real
options
Three points need to be thought through under this
subdivision. First of all, the concept of real options will be expounded; in
the second place the defining features that make an investment proposal
eligible to real options, and in the third place, what we shall name the
«competitive advantage», which such techniques can procure to private
equity firms in investment assessment of newly created firms.
Expression created by Myers (1977) and, as stated supra, the
notion of real options began to be of any centre of interest of academics in
the 80s. Since that period, there have been a number of conferences and
writings on this topic to such an extent that real options have evolved from a
less valuable topic «to one that now receives active, mainstream academic
and industry attention» (Borison , 2005, p. 17). Be that as it may, real
options method is suitable to any situation where there is a certain amount of
flexibility. In such cases, the venture capitalist is in the same situation as
the financial manager who can increase or decrease his position in a security
given predetermined conditions. A venture capital manager can also be compared
to a financial manager who holds an option. Flexibility of an investment has a
value, the value of the option associated with it. For example, in the field of
industrial investments, real options are equivalent of «the right not the
obligation, to change an investment project, particularly when new information
on its prospective returns becomes available» (Vernimmen et al., 2009, p.
374). This definite property of a flexible investment is referred to as a real
option. Conversely, in the circumstances where it is hard to recognize the
adaptability of an investment, Vernimmen et al., (2009) describe that as
«hidden options» (Vernimmen et al., 2009, p.374).
An investment proposal needs to meet three factors in order
to be qualified to real options. First, there must be some uncertainty
surrounding the project. Secondly, there should be additional information
arriving over the course of time. Thirdly, there must be the possibility to
make significant changes to the project on the basis of this information.
A number of various types of real options can be presented in
investment projects: the option to launch a new project; the option to expand,
reduce or abandon the project; or the possibility to defer the project or delay
the progress of work. According to the first type, Vernimmen et al., (2009) put
forward that it is similar to a «call option on a new business. Its
exercise price is the start up investment, [a significant element] in the
valuation of many companies. In these cases, they are not valued on their own
value, but according to their ability to generate new investment opportunities,
even though the nature and returns are still uncertain.» (Vernimmen et
al., 2009, p. 374).
Finally, the benefits of real options have been highlighted
by Krychowski and Quélin (2010) in the following way: «The main
contribution of RO [Real Option] is to recognize that investment projects can
evolve over time, and that this flexibility has value. Myers (1984) considered
that RO is a powerful approach to reconcile strategic and financial
analysis» (Krychowski and Quélin, 2010, p. 65).
As it has earlier been mentioned in this work, it could add
value to the current literature on methods assessing investment decision by
means of a survey of venture capital firms to find out what techniques they use
in practice concerning investment. Of course, a pilot study has already been
carried out in the fields of venture capitalist investment appraisal in
Australia (
Wright
and Proimos, 2005). But it was, to some extent, narrow since it was focussed on
a specific source of risk named information asymmetry, «which is caused
by lack of information on the part of the VCs, and which can lead to the added
risks of adverse selection and moral hazard» (
Wright
and Proimos, 2005, p. 272). Anyway, what are the bare bones of this literature
review?
2.4. SUMMARY OF ACADEMIC OVERVIEW OF METHODS OF
INVESTMENT ASSESSMENT USED BY PRIVATE EQUITY
Before leaving this chapter, it is useful to summarise the
main tools commonly used by private equity analysts in making investment
decisions, as noted from the literature review.
First, it should be highlighted that there does not appear to
be any previous research on this topic per se in the United Kingdom, and even
abroad. Necessarily therefore, some resort to general knowledge is called for.
There is a widespread agreement among scholars on the meaning of the concept of
private equity. Indeed, private equity is widely defined as equity «that
is not publicly traded and that is used to finance business start-ups,
leveraged buyouts, etc.» (Brealey, Myers and Allen, 2008, p. G-10; Wood
and Wright, 2009, p. 361).
Secondly, investment decision or «capital
expenditure» is the «selection of investment projects» (Arnold,
2008, p. 50). Financing decisions, as opposed to Investment decisions, are
however not within the scope of this piece of research.
Thirdly, there are many techniques used by private equity
specialists in making investment decisions. We weigh up to gather them together
this way: traditional and recent tools. Concerning classic tools, academics
such as Arnold ( 2008, p. 50); Chandra (2008, p. 116) and Vernimmen et al.,
(2009, p. 289) used the sacrosanct principle of time value of money in order to
distinguish discounted cash flows from non-discounted cash flow tools. The
former encompasses the Net present Value (NPV) and its prime competitor, that
is the Internal rate of return (IRR) techniques whereas the latter alludes to
the payback period, the profitability index and the accounting or book rate of
return.
Relating to the recent methods of evaluation of investment
proposal, they consist of real options. Created by Myers (1977), real options
have steadily been on focus in the scholars community, reaching a peak of
interest of both academics and practitioners in the early years of this
21st century as put forward by Borison (2005, p. 17). Because
investment decision is far from being, shall we say, a sort of a
«noli-me-tangere» issue, the flexibility gained from real options
makes a feature of this method. Real options are the possibility to
«modify, postpone, expand, or abandon a project» (Brealey, Myers and
Allen, 2008, p. G-11). Nevertheless, Vernimmen et al. (2009) described the
opposite of real options as «hidden options» (Vernimmen et al. 2009,
p. 374).
CHAPTER III RESEARCH METHODOLOGY
|
This chapter intends to answer the following concerns by
turns: what does the concept research means? What is research methodology? What
does research strategy mean? What is the signification of the concept of
research design? What does the notion of data collection methods express and
what is the approach adopted for this work?
3.1. WHAT IS RESEARCH?
In order to comprehend this concept, it would be worth
starting with its negative meaning, in other words, what research is not, or to
be more specific, the wrong meaning of that word. In accordance with this view,
Walliman (2005, p.8) listed four erroneous senses of «research».
First, to him a simple collection of facts or information is nothing but an
«important part of the research». Secondly, according to him,
«moving facts from one situation to another» regardless of
interpretation is far away from being the whole research; it is merely an
additional element of research. Thirdly, he further suggested that research is
not an «esoteric activity, far removed from practical life»; it is an
exploration of the universe, arisen from the strong desire to explain it
instead. Fourthly, research is not a term to «get your produce
noticed»; put it another way, in this case, research is only a result of a
seat-of-the-pants activity.
Probably, the wrong sense of the concept of research has also
something to do with its daily use in such a way that it turns out to be a
virtually commonplace. In fact, there is a sort of ubiquity of the word
«research», since it can be found in the newspapers, on television or
radio throughout wide range of phrases, such as the «findings of market
research companies' surveys», research as support of political decisions,
and «results of research» in the field of advertisement, (Saunders,
Lewis and Thornhill, 2007, p. 4). For clearing up the notion of research, we
should now turn to its proper meaning, or positive sense.
For that purpose, Walliman (2005) have put forward three
distinctive features of the concept research, videlicet a systematic data
collection, a systematic data interpretation, and an unambiguous aim, that is
«to find things out». Research therefore means «something that
people undertake in order to find things in a systematic way, thereby
increasing their knowledge» (Walliman, 2005, p. 5). The concept of
«research» can also be defined as a
«methodical investigation into a subject in order to
discover facts, to establish or revise a theory, or to develop a plan of action
based on the facts discovered» (
http://encarta.m00sn.com/encnet/features/dictionary/dictionaryhome.aspx.).
In a more concise form, Kumar (2008) argued «the search for knowledge
through objective and systematic method of finding solution to a problem is
research» (Kumar, 2008, p. 2).
Having defined what research is it seems now more suitable to
examine the concept of research methodology.
3.2. WHAT IS RESEARCH METHODOLOGY?
To provide an answer to the above question, we might need to
gather first the word methodology per se. In this respect, the term methodology
means «the system of methods followed in a particular discipline» (
http://www.elook.org/dictionary/methodology.html),
or «the study of methods of research» (http
:
//encarta.msn.com/encnet/features/dictionary/dictionaryhome.aspx).
This couple of meaning of the concept methodology only dwell
upon the word method. However, this view of the notion of methodology merely
tends to reduce that concept to one of its components. In fact, the scope of
methodology is wider and more inclusive than that as explained infra.
Concerning the phrase «methods of research», it is
devised as all the techniques that «are used by the researcher during the
course of studying his research problem» (Kumar, 2008, p. 4). Those
techniques could be formed into three groups as Kumar (2008, p. 4)
suggested:
- the first group encompasses data collection methods. They
enable the researcher facing with insufficient availability of data to get
answers that he is after.
- the second set of methods is made up of statistical tools
that help relating data to unknown.
- the third category is concerned with the techniques of
assessing the exactitude of results.
With respect to the expression research methodology, it refers
to the «theory of how research should be undertaken, including the
theoretical and philosophical assumptions upon which research is based and the
implications of these for the method or methods adopted» (Saunders, Lewis
and Thornhill, 2007, p. 602). Once again, research methodology could be viewed
as the whole lot whereas research methods are just components of that entirety.
Therefore, as Kumar (2008) concluded «when we talk of research
methodology, we not only talk of the research methods but also, consider the
logic behind the methods we use in the context of our research study and
explain why we are using a particular method or technique and why we are not
using others so that research results are capable of being evaluated either by
the researcher himself or by others» (Kumar, 2008, p. 5).
Having highlighted that, research methodology does obviously
raise the following three overriding concerns such as:
- Research philosophy or strategy
- Research Designs and
- Data collection methods.
Any single aforementioned issue is worth expounding by
turns.
3.3. WHAT IS RESEARCH PHILOSOPHY OR
STRATEGY?
To start with, a terminological precision needs to be
stressed. It is about research philosophy and research strategy. Some academics
make use of the first to allude to the second actually. For instance, Saunders,
Lewis and Thornhill (2007, p. 102), regarding what they named «research
onion», they argued that research philosophy, located in the first layer
from the surface, includes the following sets of idea: positivism, realism,
objectivism, subjectivism, interpretivism, pragmatism, radical humanist,
radical structuralist, functionalist, and interpretative. However, to their
viewpoint, research strategy encompasses experiment, survey, case study, action
research, grounded theory, ethnography, and archival research. Nonetheless, to
others the first group constitutes research strategy whilst the second should
be called research design (Bennison, 2006).
As a matter of fact, what precedes does give an account of
just a difference of terminology, because when it comes to look at the
components of each concept, we could easily conclude that they are alike. In
any case, throughout this paper we should refer to the concept of research
strategy to allude to research philosophy. Notwithstanding, when it will come
to talk about what Saunders, Lewis and Thornhill (2007, p. 102) named research
strategies, we should refer to as research design instead in order to avoid
being muddled.
Having noted that, it should be stated that research strategy
rests on the idea that it determines the basic philosophy whereby a subject
could be approached. There are a number of abstract concepts that form research
strategy as said supra, but we will only examine three out of the list, namely
axiology, epistemology, and ontology.
3.3.1. Axiology as research strategy
From Greek «axia», that is value and
«logos», that means study of, axiology can thus be defined
as that subdivision of philosophy that concerns with the study of values (
http://en.wikipedia.org/wiki/Axiology).
The usefulness of axiology as strategy of research has been
highlighted by Saunders, Lewis and Thornhill (2007, p. 110). They argued that
the values of the researcher irrigate all his work. For example, they suggested
that a selection of a given topic rather than another shows the researcher
believes the chosen topic is much more interesting. However, apart from
axiology that concerns the values of the researcher and those of the people he
interacts with, the researcher needs to be aware of the scope and nature of the
knowledge he is in search of. Epistemology meets this want.
3.3.2. Epistemology: a research strategy
The word epistemology derives from the Greek
«episteme», signifying knowledge, science, and «logos»
meaning study of (
http://en.wikipedia.org/wiki/Epistemology).
Epistemology, therefore, is a division of philosophy that deals with the nature
and scope of knowledge.
Thanks to epistemology, the researcher could differentiate
between belief and opinion. In short, there are a number of epistemological
stances that a researcher can adopt. If he or she leans towards the application
of natural sciences, he or she will be deemed to adopting positivism as
epistemological position. But, since the complexity of the social world of
business and management is reluctant to a «series of law-like
generalisations» that for example physical sciences allow (Saunders, Lewis
and Thornhill, 2007, p. 106), interpretivism would be resorted to instead. What
do we think about ontology then?
3.3.3. Ontology: a strategy of research
The concept of ontology comes from Greek «ov,
genitive» meaning of that which is, and «logia», that is study,
science, or theory, (
http://en.wikipedia.org/wiki/Ontology).
Part of metaphysic, ontology is the philosophic activity that concerns with the
existence of entities.
Boosted by the significance of the word ontology, it should
moreover be noted that as a research strategy, it implies two distinct
positions. First, the researcher could adopt an objectivist posture. This
ontological stance advocates, «things exist in reality external to
people» (Bennison, 2006).
Secondly, the subjectivism, also known as constructionism
(Remenyi et al., 1998, p.35), refers to the reverse order of objectivism. To be
more specific, a subjectivist researcher claims, «social phenomena are
created from the perceptions and consequent actions of social actors»
(Saunders, Lewis and Thornhill, 2007, p. 108).
From all what precedes, we could get a clear insight into the
concept of research strategy and shall now move on gathering the phrase of
research design.
3.4. WHAT ARE RESEARCH DESIGNS?
Alongside the research strategy, research designs appear as a
landmark of the research methodology insofar as it is a source of benchmark for
data collection. We, thus, should have a look at different research processes
before examining the various sorts of research designs as such.
3.4.1. Research processes
As far as research processes are concerned, two major types of
reasoning are on focus:
- Inductive reasoning and
- deductive reasoning.
Relating to inductive reasoning, Walliman (2005) suggested
that it consists of the «inference of a general law from particular
instances. Our experiences lead us to make conclusions from which we
generalize» (2005, p. 433). The inductive reasoning is also called
«bottom-up» approach (Bennison, 2006).
With regard to the deductive reasoning, or «top-down
approach», it works anticlockwise to that of the inductive does. In this
view, its starting point is a theory or a general idea, which gradually becomes
narrower down to hypotheses. These hypotheses are to be confirmed or not by
data collected. Be that as it may, the framework of data collection and
analysis could be in the form of some sorts of research designs.
3.4.2. Research designs
Under this subdivision, will be by turns examined the
following wide range of research designs:
- experimental design
- cross-sectional design
- longitudinal design
- case study design, and
- comparative design.
With respect to the experimental design, its aim is to examine
causal relationship effect (Saunders, Lewis and Thornhill, 2007, p. 136). There
are two types, namely the classic and the quasi-experimental design. Concerning
the former, two groups on focus are established: a treatment group and a
control group. Then people are randomly divided up to each group. There is a
pre-text of each group before the experiment and at the end of the day, there
is as assessment of dependant variable before and after the experiment.
However, in case of quasi-experiment, there is no control group and the
independent variable is measured before and after.
Concerning the cross-sectional design, it is often called
«social survey design» because it does resort to survey strategy
(Easterby-Smith, Thorpe and Lowe, 2002). According to Kumar (2010, p. 107), the
cross-sectional design, also referred to as «one shot or statues
study» constitutes the most famous design in the social sciences. Its
objective is to depict variation between people for example, and in a single
point in time. Also, the cross-sectional design is aimed at describing the
impact of a fact or an occurrence that can be observed. Moreover, it intends to
give an account of in what way factors are connected within an organisation as
suggested by Saunders, Lewis and Thornhill, (2007, p. 148).
With regard to the longitudinal design, its aims are to track
changes over time instead. Therefore, in accordance with that research design,
«the study population is visited a number of time at regular intervals,
usually over a long period» as claimed by Kumar (2010, p. 390) and Kumar
(2008, p. 10). The longitudinal research design has the distinctive feature of
allowing the researcher to manage variables that he concentrates mainly on as
long as there is no influence of research process per se on them as argued by
Adams and Schvaneveldt (1991).
Concerning the case study design, Robson (2002) conceives it
as a «strategy for doing research which involves an empirical
investigation of a particular contemporary phenomenon within its real life
context using multiple sources of evidence» (Robson, 2002, p. 178). In
2003, the relevance of the concept of context has been put forward by Yin
(2003). In fact, according to him, there is not a real watertight compartment
between the phenomenon that is subject matter of the study and the context
within which it is carried out. There are various sorts of case study designs.
When a case study aims at the veracity of a hypothesis, it is called a critical
case. However, when its purposes are to deeply understand a particular case on
the one hand, and closely investigate an issue which has been neglected on the
other hand, it is appropriately named unique case then. With respect to the
unique case study, Saunders, Lewis and Thornhill (2007) have suggested
triangulation as a method of data collection. The notion of triangulation is
regarded as «the use of different data collection techniques within one
study in order to ensure that the data are telling you what you think they are
telling you.» (Saunders, Lewis and Thornhill, 2007, p. 139). For instance,
it is possible to value a questionnaire as a technique of gathering
quantitative data thanks to semi-structured group interview. Concerning the
unit of analysis, Yin (2003) distinguishes «embedded case study» from
«holistic case study». The former consists in investigating some
sub-units of a firm, such as departments or teams whilst the latter intends to
examine the whole organisation instead.
Relating to the comparative design, it tends to give accounts
for similarities or differences in order to encourage comprehension. In doing
so, Bennison (2006) suggested the recourse to cross-sectional techniques like
cross national, cross cultural, cross organisational, cross cultural, cross
divisional methods.
In any case, whatever the research designs might be, the
researcher needs to collect data.
3.5. WHAT ARE DATA COLLECTION METHODS?
To start with, it is worth saying that data can be described
as «a series of facts that have been obtained by observation or research
and recorded» (Bocij et al., 2006, p. 794). Concerning data collection
methods, they could be identified according to the type of research strategy or
design the work has adopted. Under this section, shall we say, the
«Ariadne's thread» is to distinguish depending on whether
quantitative, or qualitative strategy is on focus.
In case of a quantitative strategy, associated with an
experimental design, the researcher has to rely, to a greater extent, on
numerical data. Furthermore, he or she will resort to a «structured
approach in order to reduce [his or her] influence on the research»
(Bennison, 2006).
In the event of qualitative strategy, connected with case
study design, the researcher will have to «use open ended methods of data
collection to capture a wide variety of opinions» ( bennison, 2006).
Anyway, data collection methods, such as structured
observations, interviews, and questionnaires sound more appropriate to
quantitative strategy. Whereas observation, semi structured Interviews,
questionnaires, focus or discussion groups appear to be suitable to qualitative
methods. Relating to questionnaires as method of data collection, it has been
devised as «a general term [including] all techniques of data collection
in which each person is asked to respond to the same set of question in a
predetermined order» (De Vaus, 2002). There are a wide a range of kinds of
questionnaires depending on the way they are administered. When a questionnaire
is filled by respondent himself, it is known as «self-administered»
questionnaire. This sort of questionnaire can be electronically answered
through internet or intranet, or mailed to respondent who will return it after
completion. Conversely, whenever a questionnaire is answered during a physical
contact with the respondent, it is named «interviewer-administered»
questionnaire as claimed by Saunders, Lewis and Thornhill, (2007, pp. 356-357).
Overall, what is the approach adopted for this study?
3.6. APPROACH ADOPTED FOR THIS STUDY
First of all, this paper does take into consideration some
research strategies like axiology, ontology and epistemology. Axiology has been
taking into account upstream from the selection of this topic. Actually,
because it seems not to exist prior research on the techniques of investment
appraisal used by private equity firms per se, we were led to all the relevance
of this exploratory research. Furthermore, in the course of surveying the
previously mentioned firms, we should be aware of their values and would be
keen to admit them without passing any sort of judgment as demands the basic
requirement of axiology strategy. Epistemology, and to be more accurate,
interpretivism is considered throughout this work due to the specificity of
business study; so, the qualitative philosophy of research will be utilised in
order to interpretate, understand and conduct a thick description of reality
of tools of investment appraisal used by private equity. Ontology is concerned
here insofar as we should bear in mind enough objectivity in making analysis of
data collected.
Secondly, as far as research design is concerned, this paper
has opted for the cross-sectional design as long as patterns of association
will be looked for and data collection will be based on electronic
questionnaires.
CHAPTER IV FINDINGS AND DATA ANALYSIS
|
The purpose of this chapter is to give an account of data
collected in order to provide answers to the research questions that pertain to
this work. To do that, as we have highlighted supra, questionnaires were opted
for as methods of collecting data. As a matter of fact, 25 venture capital
firms have received an electronic questionnaire via Survey Monkey. Only 13,
that is almost half of them have provided responses, which have been deemed as
a somewhat representative sample of the threshold population. The first task
consists in analysing answers given by those respondents and the second task
has something to do with summarising findings. Prior to these activities, it is
worth reminding that ethical considerations, such as anonymity are taken into
account in this work; thus, neither questions relating to personal details of
the respondent nor the results of this study will be published.
4.1. ANALYSIS OF DATA
In order to get a sound insight into the data collected within
the framework of this study, both the display and analysis approach of Miles
and Huberman (1994) have been adopted. Relating to data display and analysis in
this work, it deals with an organisation and comment of data that are primarily
related to research questions into diagrams. We will, therefore, give an
account of the data collected compared with the following concerns:
- What are the classic methods of analysis used in practice by
private equity firms in capital budgeting for start-ups devoid of any
flexibility?
- What is the recent practice of private equity analysts in
respect to techniques of start-ups companies flexible capital budgeting?
- What can we learn from an inquiry into the practice of
venture capitalist in the field of determining the investment decision for
newly created companies?
- Are the findings from the investigation into the way the
venture capitalists make investment decision in practice profitable to both the
main players, namely venture capital firms and new entrepreneurs?
4.1.1. Traditional tools of analysis used in practice
by venture capitalist in making investment decision
We can learn from information gathered that Private equity
firms, whatever industries they belong to (as shown on the first graph
hereafter), do utilise classic methods for evaluating proposals. Those
techniques include discounted cash flows methods such as the Net Present Value
and the Internal Rate of return. Furthermore, venture capitalist does also
resort to non-discounted cash flows methods, notably the payback rule, the
profitability index and the accounting or book rate of return in making
investment decision. These successive graphs are therefore an illustration of
that state of affairs.
The above column chart indicates the 07 sorts of industries
within the dozen of Private equity firms that have been surveyed could probably
invest. On the whole, it is clear that Private equity analysts rather preferred
health care and Consumer goods and services investment proposals to any other
out of the list.
In fact, there was a sharp identical percentage, notably 33.3
percent, in the number of private equity, which could happily grant funds to
technology industries start-ups as well as financial ventures. Concerning the
former, telecommunication sector itself, included fixed line and mobile, and
information technology were parts of technology sector. Relating to the latter,
real estate, financial services per se, figured in financial component part. In
addition, there was another identical proportion in the number of industry
sectors selected by private equity organisations. In effect, approximately 8
percent of private equity analysts were choosing to spend money on basic
materials, and oil and gas sectors likewise. Basic materials referred to
chemicals, forestry and paper, industrial metals and mining, whilst oil and gas
comprise alternative energy, oil and gas producers, and oil equipment services
and distribution.
However, only probable acceptances of industrial investment
projects represented a sixth of the number of private equity organisations on
focus here. Industrial proposals alluded to aerospace and defence, construction
and materials, electronic and electrical equipment, engineering, general
industries, support services and transportation.
To sum up, it can be seen that Health care industry sector
constituted the most popular choice out of the seven kinds of sectors of
industry. Notwithstanding, private equity analysts did utilise classic methods
for appraising venture start-up companies, regardless of the sector of industry
they belonged to as demonstrated infra.
The above pie chart displays information about the percentage
of techniques that take into consideration the sacrosanct principle of the time
value of money in making investment decision for new ventures. Overall, it is
obvious that the Internal Rate of return was the discounted tools of analysis
most used by private equity in making investment appraisal.
As a matter of fact, the percentage of private equity firms
that resorted to the Internal Rate of Return (IRR) constituted roughly the
double of the proportion of those that utilised the Net Present Value (NPV),
namely almost 67 percent.
To conclude, there is no doubt that the Internal rate of
Return was by far the most popular method used by private equity analysts for
making investment decision for start-ups. It should be worth moving on the
question of what private equity firms think about these two classic discounted
cash flows methods.
This stacked bar chart illustrates the views that surveyed
private equity analysts took about the utility of a couple of discounted cash
flows methods for capital expenditure of newly created firms. Generally
speaking, the IRR technique did attract numerous private equity analysts.
In fact, as far as one of the overriding rules of financial
theory is concerned, namely the time value of money, roughly half of the
venture capital firms analysts did tend toward the use of the IRR method.
Although there was one skipped question concerning this category, it did not
affect the final results in terms of dominance of the IRR technique. Indeed,
the results relating to NPV as discounted cash flows were completed and less
than half of respondents were in favour of that method. Conversely, 6 among 12
private equity firms analysts did prefer IRR technique. The unique assumption
that we could make is that if the participant who refrained from answering to
that question selected any option apart from «agree», the superiority
of IRR would still be valid.
Moreover, the trend of the prime importance of the IRR was
further strengthened by the number of people who strongly disapproved the NPV
as a practical means of evaluating start-ups investment proposals. Actually,
only one venture capital analyst disagreed with the use of IRR whereas two
people did not share the view that the NPV rule does recognise the principle of
the time value of money.
With regard to the point of mutual exclusive proposals and the
use of the NPV technique, it is clear that there was an enormous increase in
the number of neutral participants, approximately 60 percent. Furthermore,
there was a slight drop in the number of approvals of NPV as one useful
technique of making investment decision for start-ups in case of non-concurrent
projects.
In conclusion, regarding the opinion of private equity
analysts about the usefulness of discounted cash flows tools of evaluating
start-ups capital expenditure, the IRR method was more popular than its
competitor, namely the NPV, notwithstanding one skipped question in the number
of respondents related to the IRR as a discounted cash flows technique. This
trend has been confirmed even in a more general aspect as shown in the next
diagram.
The pie chart that appears at the bottom of the previous page
displays information about the percentage of choice of two discounted cash
flows methods for appraising start-up companies. On the whole, the gap in the
selection between the IRR and NPV method by private equity analysts was not
that large.
As a matter of fact, more than the half of the participants
were attracted by the IRR as a technique of evaluating capital budgeting for
newly created ventures. To be more specific, 53.8 percent of private equity
firms did prefer IRR method to the NPV technique.
Nonetheless, NPV as a tool of analysis of investment appraisal
of start-up firms was only selected by 46.20 percent of private equity firms
that took part in this survey.
Finally, it is obvious that private equity analysts do prefer
the IRR method to the NPV tool when it comes to make investment decision for
start-up companies. These results seemed far too much similar to the findings
of Graham and Harvey (2001) released 10 years ago. Their results showed that
«74.9% [Chief Finance Officers] always or almost always use the internal
Rate of return», which was roughly 1% more than those who referred to the
Net present value criterion (Graham and Harvey, 2001, p. 193). Nevertheless,
some distinction still needs to be drawn since Graham and Harvey (2001) did
survey only Chief Finance Officers of 4,400 American firms, with the exception
of Venture capital organisations. We should now move on finding out what the
information collected reveals with respect to the use of non-discounted cash
flows methods for capital expenditure of new ventures.
This line graph demonstrates the number of private equity
firms that utilised non-discounted cash flows methods in making investment
decision for start-up companies. As far as the overall trend is concerned,
there was a gradual decline in the number of users of methods, which did not
take into consideration the sacrosanct rule of the time value of money in
making capital expenditure decision for start up companies.
At the beginning, among the 13 private equity analysts who
took part in this survey five confirmed that they utilised the payback rule as
a non-discounted cash flows technique of evaluating capital budgeting proposals
for newly created ventures. That was a sharp percentage of 41.7.
In contrast, 33.30%, that is to say four respondents chose
the profitability index; only a quarter was interested in the accounting or
book rate of return as a criterion of an investment decision into start up
firms' proposals. Unfortunately, there was one skipped question with respect to
the issue of the use of non-discounted cash flows methods for appraising
capital budgeting of start up companies; therefore, the above-mentioned
proportions are no more and no less symptomatic of 12 effective respondents.
In a completely different respect, it has been argued that,
although it was in a more general perspective, among non-discounted cash flows
methods of capital budgeting the accounting or book rate of return looks like a
poor relation with approximately 12 percentage of use by Chief Finance Officers
(Graham and Harvey, 2001, p. 193). This trend has been somewhat confirmed here
as long as only 25 percent of private equity analysts did say they resorted to
that technique of capital budgeting for start up companies.
By way of conclusion, it can be seen that the payback rule was
the most attractive technique among private equity organisations as far as
non-discounted cash flows techniques that they resorted to in making investment
decision for start-up companies were concerned. We should now examine the
viewpoint of these private equity analysts about the realistic aspect of the
previously mentioned non-discounted cash flows methods for evaluating
investment decision for start up organisations.
The above chart constitutes an illustration of information
concerning the perception that 13 private equity firms had about the practical
aspect of three non-discounted cash flows tools of analysis for start-ups'
capital expenditure. On the whole, it is obvious that point of views did not
wildly fluctuate between the payback rule, the profitability index and the
accounting or book rate of return.
Without any doubt, about 50 percent, in other words 6 out of
12 ( because there was one skipped question) private equity firms thought that
the payback rule, as a method for evaluating investment decision for newly
created ventures, was practical.
In addition, 4 private equity analysts out of 12 who really
did answer this question, were attracted by the realistic feature of the
accounting or book rate of return. This number stood for roughly 33 percent of
the whole responses relating to the issue of the practical characteristic of
non-discounted cash flows techniques of appraising start ups capital budgeting.
Conversely, the non-discounted cash flows method of capital
expenditure for start-up organisation regarded as the least realistic, turned
out to be the accounting or book rate of return. Oddly, only a sixth of private
equity firms thought that that capital budgeting technique was practical for
start up companies whilst a quarter previously claimed its utilisation in
accordance with the results of the previous line graph that appeared at the
bottom of page 34 of this work. Probably, there were other bases of that use,
which the participants did not specify even though they have been suggested to
do so within the framework of the questionnaire.
To sum up, it is clear that when it came to make investment
decision for start up companies based on non-discounted cash flows methods,
private equity analysts did consider the payback rule as more realistic than
the two other techniques, namely the accounting or book rate of return and the
profitability index. This work will hereafter inquire data in comparison with
start up companies' capital budgeting where proposals cannot be adapted to a
new situation.
This bar chart is a display of information about the best
techniques that private equity analysts referred to when it comes to make
capital budgeting decision that is devoid of any flexibility for newly created
ventures. In general, for that purpose, all participants tended toward choosing
among one of these methods, namely the profitability index, the payback period,
and the NPV, excepted for the IRR.
As a matter of fact, a third of private equity analysts did
prefer the Net present Value method in making non flexible capital budgeting
decision for start up firms.
However, according to a quarter of private equity firms, the
accounting or book rate of return was the best tool of analysis that they
referred to in making non flexible investment decision for start up companies.
Moreover, the same proportion considered the profitability index technique and
the payback period as the best method of analysis on the subject
aforementioned. Nevertheless, the IRR technique looked like a poor relation in
the eyes of private equity analysts. In fact, none of the 13 private equity
analysts who took part in this survey regarded this method as a useful
technique in making non-adaptable investment decision for newly created
ventures.
In summary, when it comes to make start up companies
investment decision devoid of any flexibility, a simple majority of 4 out of 13
private equity analysts did prefer relying on the NPV technique rather than
others classic methods such as the payback rule, the profitability index, and
the accounting or book rate of return. The comment on this trend is that one of
the Net Present Value's principal challengers, the Internal rate of Return
method, has to say the least been downgraded, even ignored by the respondents.
The peculiarity of these results stands out against prior research on the use
of traditional methods of making investment decision in corporate finance as
shown by scholars such as Graham and Harvey (2001, p. 193). Having said that,
what practical tool of analysis do private equity firms resort to in making
flexible investment decision for start-ups organisations?
4.1.2. Recent technique of analysis used in practice
by venture capitalist in making flexible and reversible investment decision for
start-up companies
The aim of this subdivision is to describe and explain the
points of view of 13 private equity analysts with regard to the tools they use
in making flexible investment decision for newly created ventures. Because
capital budgeting seems far from being a commonplace decision on the one hand,
and completely lacking of adaptability to new circumstances on the other hand,
the financial theory developed by scholars like Myers (1977), Borison (2005, p.
17), Vernimmen et al., (2008, p. 374), Krychowski and Quélin, (2010, p.
65) has put forward real options. This work will thus make some incidental
comparisons with previous studies. Boosted by what precedes, we should
therefore examine viewpoints of private equity analysts as successively shown
in the following figures.
Methods used by private equity analysts in making
flexible investment decision for start-ups companies
|
Response count from 8 private equity analysts
|
Percentage
|
IRR
|
2
|
25%
|
NPV
|
3
|
37.5%
|
Real options
|
1
|
12.5%
|
The accounting or book rate of return
|
1
|
12.5%
|
The payback rule
|
1
|
12.5%
|
The profitability index
|
1
|
12.5%
|
Table 1: What do you resort to in making flexible
investment decision for start-ups organisations?
The above table is a display of 08 out of 13 viewpoints of
private equity analysts (as long as there were 5 skipped questions) with
respect to the methods that they resort to when the investment projects
submitted to them by start-ups are adaptable and / or reversible. Broadly
speaking, it can be noticed that their opinions were eclectic enough.
First of all, 3 over 8 private equity analysts did maintain
that they had recourse to the Net Present Value method of capital budgeting for
newly created ventures. That figure stood for 37.5 percent and was the most
used technique as far as private equity firms were concerned when it comes to
make flexible investment decision for start-up companies. Moreover, a quarter,
in other words 25 percent of these private equity analysts has claimed an
exclusive recourse to the Internal Rate of Return.
However, only 12.5 percent of the respondents said that they
utilised one of the following tools of analysis in assessing start-ups capital
budgeting : real options, the accounting or book rate of return, the payback
rule, and the profitability index.
To conclude, the findings regarding the techniques that
private equity analysts do have recourse to in evaluating start-ups flexible
capital expenditure clearly demonstrate the prime importance of NPV method over
others. This result is surprising at least for a couple of reasons. In the
first place, the shortcomings of the NPV tool of analysis per se have been
deplored in a numerous financial academic writings as noted earlier in this
work on page 10. Secondly, Net Present value does ignore «the value of
managerial flexibility, in other words the options that the manager can exploit
after an investment has been made in order to increase its value»
(Vernimmen et al., 2009, p. 297). In the face of this situation, there is no
need to make a mountain out of a molehill as long as private equity analysts
should refer to real options in order to adjust the aforementioned NPV's
restricting flaws.
Table 2: How do you rate Real options relating to
making better flexible capital expenditure decision for start-up
organisations?
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
Rating average
|
Response
count
|
Real options provides us with a better adaptability in the
management of proposal
|
0.0%
(0)
|
0.0%
(0)
|
0.0%
(0)
|
8.3 %
(1)
|
50%
(6)
|
16.7%
(2)
|
0.0%
(0)
|
16.7%
(2)
|
0.0%
(0)
|
8.3% (1)
|
6.00
|
12
|
The table that comes into view at the bottom of the previous
page displays information about the rating scale of real options as a technique
of appraising flexible start-up firms' capital expenditure as far as private
equity analysts are concerned. Overall, it is obvious that there was a
substantial participation on behalf of private equity analysts regarding that
question because 12 out of 13 private equity firms did give an effective
response to that issue.
To start with, half of private equity analysts set value on
real options as a technique whereby they evaluated flexible proposal from
start-up companies. Indeed, on the scale of 10, 50 percent of respondents gave
a rate of 5 to real options like a satisfactory tool of assessing reversible
and / or flexible start-ups investment projects.
Furthermore, there was a double similarity in the number of
respondents who concurred that real options were a helpful technique for making
better flexible investment decision. Firstly, 8.3% of private equity analysts
ascribed a rate of 4 over 10 to real options on the one hand, and a rate of 10
over 10 to real options on the other hand. The latter rate sounded somewhat
astonishing and probably derived from the unique private equity analyst who
pretended to refer to real options method according to the previous table.
Secondly, roughly twice of the previous percentage, (in other words 16.7%)
regarded real options as a useful method for evaluating start-up companies'
flexible capital budgeting. In accordance with this viewpoint, 2 people gave a
rate of 6 over 10 and 8 over 10 to real options respectively.
However, the scale rates of 1 to 3 as well as 7 have not been
selected at all by private equity analysts in rating real options as a method
that helps improving the evaluation of start-up companies' capital budgeting.
To sum up, it is clear that the rating average of real options
conceived as a helpful technique that improves the adaptability of investment
decision as far as start-ups companies was 6.00. We should now move on the
question to find out the most used method for evaluating capital expenditure of
start-up organisations regardless on the potential flexibility or not of the
proposals.
Table 3: Out of the following, what is the most used
technique in appraising project in your organisation?
Methods
|
Response percent
|
Response count
|
NPV
|
33.3
|
4 over 12
|
IRR
|
8.3
|
1 over 12
|
The payback rule
|
33.3
|
4 over 12
|
The profitability Index
|
25.0
|
3 over 12
|
The accounting or book rate of return
|
0.0
|
0
|
Real options
|
0.0
|
0
|
This table shows information with regard to the most
attractive technique of investment appraisal used by 12 over 13 private equity
analysts (because there was one skipped question). As far as the overall trend
is concerned, it is clear that those private equity analysts were attracted by
methods such as NPV, IRR, the payback rule, the profitability index, except for
the accounting or book rate of return and real options.
To begin with, a third of private equity analysts said that
the most used techniques for assessing investment projects submitted to them by
start-up organisations were both the NPV and payback
period methods. Therefore, we could argue that those two tools of
analysis, which are discounted and non-discounted cash flow techniques
respectively, were equally placed. These findings appear to be inconsistent in
relation to those expounded at an earlier occasion supra, for example on page
34, under figure 2. To tell the truth, it is not the case. In fact, the
finding, which stated that the NPV and payback period techniques were equally
placed by private equity analysts, came from the question intending to
determine which of the seven methods met with the greatest extent or frequency
of utilization, regardless of its discounted or non-discounted characteristic.
However, the results that regarded the NPV method as the most used discounted
cash flow technique (as derived from analysis of figure 2 that appeared on top
of page 34) aim at selecting between two discounted cash flow techniques,
namely the NPV and the IRR.
Besides, only a quarter of private equity analyst said to make
largely use of the profitability index whilst the IRR technique has, strangely
enough, been most utilised by just 8.3 percent of private equity analysts.
Unfortunately, the worst case comprised the accounting or book rate of return
and real options techniques, which scored 0.0 percent of frequency of
utilization.
To conclude, it is clear that private equity analysts had
recourse to a couple of techniques, notably the NPV and the payback rule, to
the greatest extent. As a result, the rest of five methods were further to be
in the forefront. Be that as it may, it seems worth summarising the findings of
this data analysis, which constitutes the second task of this chapter as stated
right at the beginning.
4.2 SUMMARY OF FINDINGS
The aim of this section consists in summarising the findings
that derived from the analysis of data collected by means of an electronic
questionnaire (comprising 10 questions as a sample is appended) sent to 25
private equity firms. Only 13 over those 25 private equity firms did return
their responses to us with regard to the tools of analysis they referred to
when it came to make investment decision for start up companies. These 13
participants, in other words roughly 50% of the threshold population, were
deemed enough meaningful of the aim of catching on the practice of private
equity organisations regarding methods of assessing start ups' capital
budgeting. At any rate, in order to give a shortened version of the findings,
we should refer to its main points that provide answers to the research
questions that pertain to this work.
To start with, as far as sectors of industries were concerned,
information collected taught us that 50 percent of private equity firms were
happier with investing in Health care and approximately the same percentage in
Consumer goods and services likewise. These findings would probably be
beneficial to both parties involved because any start-up company would submit
an investment proposal, which belongs to a relevant sector of industries for
example.
With regard to the classic tools of analysis, which could be
used by private equity firms in making investment decision for start-ups, we
found that they resorted to both discounted and non-discounted cash flow
techniques. Relating to the former, results demonstrated that 66.70 percent of
private equity analysts did utilise the IRR technique whereas 33.30 percent
claimed using NPV method. Moreover, that trend of the dominance of the IRR
method over the NPV technique has been sealed by answers on what was the
preference of private equity analysts out of those two techniques on the one
hand. In fact, 53.80 percent said preferring the IRR technique whilst 46.20%
selected the NPV method. These results appeared to get, shall we say, a sort of
«family ties» with the findings of Graham and Harvey (2001) released
10 years ago. Their results showed that «74.9% [Chief Finance Officers]
always or almost always use the internal Rate of return», which was
roughly 1% more than those who referred to the Net present value criterion
(Graham and Harvey, 2001, p. 193). Nevertheless, our results still stand out
from Graham and Harvey (2001) findings as long as they did survey only Chief
Finance Officers of 4,400 American firms, with the exception of Venture capital
organisations, which were on focus here instead. Furthermore, the viewpoint of
private equity analysts relating to the usefulness of those methods was another
confirmation of the superiority of the IRR on the second hand. For the sake of
illustrating, when asked to choose between IRR and NPV, the method that most
abode by the sacrosanct principle of time value of money, roughly half ( that
is to say 6 over 12 because of one skipped question) of the venture capital
firms analysts did tend toward the use of Internal Rate of Return (IRR).
With respect to non-discounted cash flow method for
evaluating newly created ventures' capital expenditure, 41.7% of venture
capital analysts said using the payback period. In addition, when assessing
investment proposals from start up companies, 33.3 percent of private equity
analysts referred to the profitability index technique and only a quarter
claimed the utilisation of the accounting or book rate of return as a criterion
of an investment decision into start up firms' proposals. These latter findings
could be regarded as an echo of the widely known argument that among
non-discounted cash flow methods of capital budgeting, the accounting or book
rate of return looks like a poor relation with approximately 12 percentage of
use by Chief Finance Officers (Graham and Harvey, 2001, p. 193).
Another concern, which has possibly been sorted out by
findings from surveying venture capital organisations, had something to do with
their points of view with respect to the accuracy of non-discounted cash flow
methods for evaluating start up firms' capital budgeting. In fact, 50% did
approve the realistic aspect of the payback rule in making investment decision
for start up companies when roughly 33% did so for the accounting or book rate
of return.
Nonetheless, the non-discounted cash flows method of capital
expenditure for start-up organisation regarded as the least realistic, turned
out to be the accounting or book rate of return. There seemed to be something
odd about this latter finding. In fact, only a sixth of private equity firms
thought that the accounting or book rate of return, as a capital budgeting
technique, was practical for start up companies whilst a quarter previously
claimed its utilisation in accordance with the results of the previous line
graph that appeared at the bottom of page 38 of this work. This result sounded
to suggest that the percentage of use of the accounting or book rate of return
was higher than that of its satisfaction, which its users could have with
respect to its accuracy. To tell the truth, the reason of such a discrepancy in
these percentages resides somewhere else. Probably, there were other bases of
the use of accounting or book rate of return, which the participants did not
specify even though they were required to do so within the framework of the
questionnaire ( In fact, a line for «other» has been provided under
this question yet).
As far as techniques used by venture capital analysts in
making capital budgeting decision for start up organisations, which are lacking
even a dash of flexibility were concerned, we found that a third of those
analysts said referring to NPV. Conversely, one of main competitors of NPV
technique, in other words the IRR method, has not been selected at all. This
result sounded in contradiction with the classic corporate finance theory as
illustrated by academics such as Graham and Harvey (2001, p. 193), Brealey,
Myers and Allen (2008).
Concerning the method used by venture capital analysts when it
comes to make flexible investment decision for newly created ventures, findings
demonstrated that there was a somewhat eclectic taste in the answers of
participants. As a matter of fact, the NPV method was in the lead with 37.5% of
use when real options only scored 12.5%.
But the poor score of real options has been improved when
private equity firms were asked to say to what extent they were happy with
using a recent tool ( that is to say real options), which provides private
equity analysts with better adaptability in the management of start-ups'
investment. Indeed, 50 percent of venture capital analysts did approve the view
that real options met their need of flexibility in making start-up firm's
capital expenditure decision. This result was deemed symptomatic of the
progress in practice of real options, despites its recent character as method
for evaluating capital budgeting decision.
At last, private equity analysts were asked to state the
technique of investment appraisal that they more often resort to. Our findings
showed that a couple of techniques, notably the NPV and the payback rule, were
used in the greatest extent. As a result, the rest of five methods were further
to be in the forefront.
CHAPTER V CONCLUSION AND RECOMMENDATIONS
|
Highlighting the main points of this work on the one hand and
making relevant suggestions on the other hand, are the purpose of this chapter.
Notwithstanding, a sort of, shall we say, `exit' section will mainly
concentrate on limitations because none of academic writing can neither be
excellent or ideal in every way, nor an easy concern.
5.1. CONCLUSION
To begin with, in chapter one, which dealt with the
introduction, we have outlined that the context of this research resides on the
discussion between academics about the cause of the significant decline in the
number of investment activities of venture capital organisations. Indeed,
according to the British Venture Capital Association (BVCA), 3
years ago, 1680 firms were funded by private equity while in 2009 only 987
organisations obtained similar funds (Private Equity and Venture Capital
Report on Investment Activity, 2009).That fall could be due to the 2008
global economy collapse in the eyes of some. However, investors' behaviour
probably was an explanation of the aforementioned decline maintained other
(Roszkowski and Davey, 2010, p. 43).
Because we agreed with the latter scholars, our aim was to go
beyond the notion of investing behaviour and find out the various techniques,
which they have recourse to in making investment decision for newly created
ventures. In doing so, our objectives were first to investigate the classic
tools of analysis, which could be found in the financial literature. Secondly,
our aim was to determine the applicable technique in case of evaluating
flexible and reversible start-ups' investment proposals. Thirdly, our objective
consisted of conducting a survey of venture capital analysts to find out their
practice by way of capital budgeting for start-ups. In the fourth place, this
dissertation was aimed at suggesting beneficial solutions to both parties
involved in making such an investment decision, that is to say private equity
analyst and start-up company.
Achieving the goals previously mentioned demanded some
research queries. Therefore, the following questions were raised: what are the
classic methods capable of helping venture capitalist to make investment
decision devoid of any flexibility with regard to start-up companies? In case
the newly created firm's project gets some flexible and reversible aspects, how
should the venture capitalist make investment decision? What can we learn from
an inquiry into the practice of venture capitalist in the field of determining
the investment decision for newly created companies? Are the findings from the
investigation into the way the venture capitalists make investment decision in
practice profitable to both the main players, namely venture capital firms and
new entrepreneurs?
As far as the second chapter, which was entitled literature
review was concerned, there seemed not to exist in the United Kingdom, and even
abroad prior research itself on financial tools of analysis commonly used by
private equity in assessing start-ups capital expenditure. In order to give an
account of the relevant scientific writings that pertain to this work, we
opted, therefore, for a deductive reasoning. In other terms, we resorted to
some general knowledge contained in both books and articles and relating to any
key word of our topic. Thus, from doing so it emerged that the concept of
private equity was generally regarded both in the eyes of scholars (such as
Brealey, Myers and Allen, 2008, p. G-10; Wood and Wright, 2009, p. 361), and
professionals (namely, the BVCA, 2010, p.14), as money invested in venture and
not listed companies. Moreover, regarding the meaning of the term start-up
firm, it referred to as a start-up company or «startup» is a
company with a limited or
non-existing operating history (Arnold, 2004, p. 388). Furthermore, the notion
of investment decision was devised as synonymous with capital budgeting
decision (Brealey, Myers and Allen, 2008, p. 4) or «Capital expenditure
-capex-», that is the «selection of investment projects»
(Arnold, 2008, p. 50).
Concerning the financial theory on tools of analysis used by
private equity in making investment decision, as mentioned earlier in this
conclusion, there did not appear to be prior research in the United Kingdom,
and even abroad. To tell the truth, numerous scholars tended to focus in
particular on standards that venture capital firms refer to in making
investment decision. For the sake of illustration figured the works of authors
such as MacMillan, Siegel and Subbanarasimha (1985), MacMillan, Zemann and
Subbanarasimha (1987), and Zacharakis and Meyer (2000). Primarily, the
aforementioned benchmarks are consisted of four components: firstly product
characteristics, secondly market characteristics, thirdly company's financial
position and outlook, and finally the characteristics of the entrepreneur or
management team. Besides, a survey of four Australian venture capital firms has
been conductor by
Wright
and Proimos (2005). These authors found that those organisations did utilise
Berger and Udell's (1998) three stages of investment model, that is to say
selection, contracting and monitoring. To the credits of their paper, we
thought that it seems to be a clear and recent contribution to the
understanding of the series of actions taken into consideration by private
equity for making investment decision. Nevertheless,
Wright
and Proimos (2005) did not dwell that much upon the methods as such used whilst
appraising capital budgeting proposals. Boosted by all what precedes, we were
to scrutinise the general financial knowledge on methods of evaluating
capex.
In accordance with this view, there were both classic and
recent techniques of making investment decision. As far as the former methods
were concerned, we took up the distinction between discounted cash flow and
non-discounted cash flow methods. The rule of thumb on which resided that
difference was the sacrosanct principle of time value of money as argued by
Arnold (2008, p. 50), Chandra (2008, p. 116), and Vernimmen et al. (2009, p.
289). Net present value (NPV) and Internal rate of return (IRR) were components
of the discounted cash flow techniques. Broadly speaking, NPV was conceived as
«project's net contribution to wealth» (Brealey, Myers and Allen,
2008, p.G-9). In referring to NPV method for evaluating a project, it was clear
that a positive NPV meant that shareholder's wealth was better off when a
negative NPV was tantamount to a non acceptance of the project. Because NPV
was far from being a supposed for all investment appraisal problems, its flaws
were highlighted by Vernimmen et al., (2009). He has criticised the lack of
easiness in working it out instinctively and directly. In addition, to him NPV
did not have a dash of high opinion of «the value of managerial
flexibility, in other words the options that the manager can exploit after an
investment has been made in order to increase its value» (Vernimmen et
al., 2009, p. 297).
The shortcoming of NPV, which had something to do with its
complex calculations, had been overcome by one of the NPV's principal
competitors, in other words the IRR technique. This was defined by Brealey,
Myers and Allen as the «discount rate at which investment has zero net
present value» (Brealey, Myers and Allen, 2008, pp. G-7). Regarding the
IRR calculation, academics suggested that it was found with the help of
«trial and error» in a customary way (Droms and Wright, 2010, p.
194). With respect to the IRR rule by way of investment appraisal, it simply
states that whenever the rate of return of an investment is beyond the minimum
acceptable rate of return on a project of an investor, it is accepted
(Vernimmen et al., 2009, p. 309; Brealey, Myers and Allen, 2008, p. 123).
However, we found that the IRR method, likewise the NPV its challenger, could
undergo some limits. In fact, Brealey, Myers and Allen (2008) have pointed out
a wide range of problems with the application of the IRR technique. Indeed,
many internal rates of return for a project could result from lots of changes
in the sign of cash flows. In addition, in case of proposals that are mutually
exclusive, the IRR probably provided with a deformed idea of the projects
value. As a final point, the IRR method did make a clean sweep of the relative
size of projects. (
http://portal.lsclondon.co.uk/resources/course/view.php?id=871).
Other than the NPV and IRR techniques of evaluating capex on
the basis of discounted cash flows, we investigated non discounted cash flow
methods, such as the Payback period, the Profitability index, and the Book or
Accounting rate of return. As far as the Payback period was concerned, we
learnt that it consists of selecting «any project with the shortest
payback period» (Droms and Wright, 2010, p. 191). According to Brealey,
Myers and Allen (2008), two examples of thing could go wrong with the payback
technique. First, it does not encompass «all cash flow after the cut-off
date; [secondly, the] «payback rule gives equal weight to all cash flows
before the cut-off date» (Brealey, Myers and Allen, 2008, p. 121). With
respect to the profitability index, the golden rule was to only choose the
projects with the uppermost NPV per pound of initial amount of money spend.
Relating to the book or Accounting rate of return, finally, Brealey, Myers and
Allen (2008) taught us that it aimed at finding the potential book income
«as a proportion of the book value of the assets that the firm is
proposing to acquire» (Brealey, Myers and Allen, (2008, p. 119). Because
the book rate of return is a sort of means across the total activities of the
organisation, we considered that it was unlikely to be worthwhile dwelling too
much upon it. As a matter of fact, we were exclusively focussed on the methods
private equity use for investment decision making for start-up companies.
As far as recent tool of appraising capital budgeting was
concern, we found the need of flexible investment proposals had been met by
real options. In fact, flexibility of an investment has a value, the value of
the option associated with it. For the sake of example, Vernimmen et al.,
(2009) have suggested that in the field of industrial investments, real options
are equivalent of «the right not the obligation, to change an investment
project, particularly when new information on its prospective returns becomes
available» (Vernimmen et al., 2009, p. 374). Moreover, we took up the
advantageous view of real options as highlighted by Krychowski and
Quélin (2010) in the following way: «The main contribution of RO
[this stands for Real Options] is to recognize that investment projects can
evolve over time, and that this flexibility has value. Myers (1984) considered
that RO is a powerful approach to reconcile strategic and financial
analysis» (Krychowski and Quélin, 2010, p. 65).
We needed to find answers to research questions that pertained
to this paper. Therefore, the primary purpose of the third chapter was to
comprehend the notion of research methodology in the first place, and expound
the approach that we selected in order to achieve our set objectives in the
second place. With regard to the former aim of the third chapter, we shared the
viewpoint of Saunders, Lewis and Thornhill on the notion of research
methodology. In fact, it could be defined as the «theory of how research
should be undertaken, including the theoretical and philosophical assumptions
upon which research is based and the implications of these for the method or
methods adopted» (Saunders, Lewis and Thornhill, 2007, p. 602).
Relating to the latter aim of that third chapter, we outlined
the approach used in this work in order to attain our objectives. In this
respect, we argued that this paper did take into consideration some research
strategies like axiology, ontology and epistemology. Axiology was taken into
account upstream from the selection of this topic. Actually, because it seemed
not to be prior research on the techniques of investment appraisal used by
private equity firms per se, we were led to all the relevance of this
exploratory research. Furthermore, in the course of surveying the previously
mentioned firms, we were aware of their values and strove to admit them without
passing any sort of judgment in accordance with the core requirement of
axiology strategy. Epistemology, and to be more accurate, interpretivism was
considered throughout this work due to the specificity of business study; so,
the qualitative philosophy of research was be utilised in order to
interpretate, understand and conduct a thick description of reality of tools of
investment appraisal used by private equity. Ontology was concerned here
insofar as we were to bear in mind enough objectivity in making analysis of
data collected. Finally, as far as research design was concerned, this paper
opted for the cross-sectional design as long as patterns of association has
been looked for and data collection based on electronic questionnaire designed
with the help of a software called Survey Monkey.
From the fourth chapter, which dealt with data analysis and
findings, it emerged firstly that 50 percent of private equity firms were more
attracted by investing in Health care and roughly the same proportion in
Consumer goods and services than technology industries, financial ventures,
Basic materials, oil and gas, and industrials. Secondly, as far as techniques
used by venture capital analysts in making capital budgeting decision for start
up organisations, which are lacking even a dash of flexibility were concerned,
we found that a third of those analysts said referring to NPV. In this respect
and conversely, the revelation appeared to be that private equity analysts in
making non-flexible investment decision for start-up firms did make a sweep
clean of the IRR technique. Thirdly, by way of making flexible capital
budgeting decision for start up organisations, the NPV method was in the lead
with 37.5% of use when real options only scored 12.5%. However, relating to
that latter tool of analysis and the viewpoint of their users on the
satisfaction they got from it, 50 percent of venture capital analysts did
approve the view that real options met their need of flexibility in making
start-up firm's capital expenditure decision.
5.2. RECOMMENDATIONS
This paper was focussing on the tools of analysis commonly
used by private equity in making investment decision. Broadly speaking, we
noticed that private equity analysts did make capex decision in accordance with
the general final knowledge as imparted by most of the textbooks. However, some
suggestions could be made in such a way those investment decision be more
fruitful and realistic. In addition, recommendations for further research have
been taken into consideration.
Concerning this paper per se, the following recommendations
are proposed:
Ø Private equity analysts should at least be aware of
the use of IRR method and its advantages by way of making non-flexible
investment decision for start up organisations.
Ø In case of flexible capital budgeting projects for
newly created ventures, venture capital analysts should only refer to real
options, so long as real options are the recent tool tailored for that
purpose.
Ø In order to come off better, start up firms should
strive in submitting investment projects that belongs to one of the most
attractive sector of industry in the eyes of private equity analysts, namely
health care and / or consumer goods and services.
Ø Most should be done in order to further make real
options wildly understandable and appreciate by professionals.
As far as new area of research is concerned, we would suggest
that:
· A sound inquiry into the private equity analysts'
practice of real options appears to be relevant in understanding its relative
achievement by way of investment appraisal for start up organisations.
· A paper, which only focuses on project analysis per se,
would be both beneficial to all the parties involved. To be more specific, an
exploration study of the usable techniques like Monte Carlo simulation,
break-even analysis, and sensitivity analysis of identifying critical factors,
which could undermine a start-up's project, should be significant.
5.3. LIMITATIONS
Just like any other human activities, conducting a research
appears not to be a small task. This sort of `exit' section aims at outlining,
therefore, some factors that stood in the way of the easy progress of this
piece of work.
Because there seemed not to be prior studies on the tools of
analysis commonly used by private equity in making investment decision for
start up companies in the United Kingdom and even abroad, we were to collect
primary data in order to be consistent in our findings. In doing so, some
private equity firms refrained from taking part in our survey under the grounds
of confidentiality and privacy of the information needed. On top of that, they
argued that their schedule at work was busiest.
In response to those difficulties in getting information, we
were to opt for an electronic questionnaire as a non-time consuming way of
collecting data and did attach a cover letter to the electronic mail that we
sent to our sample population made of 25 private equity firms. At the end of
the day, half of them were kind enough to come back to us.
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3. Arnold G., 2008, Corporate Financial Management,
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APPENDIX
QUESTIONNAIRE SAMPLE
This survey comes within the academic framework of a
Master in Business Administration dissertation in Finance, currently written by
the interviewer. The aim of this questionnaire is to find out more about actual
practice of private equity analyst in investment appraisal. There will neither
be any question relating to personal details of the respondent and the results
of this survey will nor be published. Therefore, the entire voluntary
participation of the respondent as well as the confidentiality of his answers
is absolutely ensured. Your opinion is very important and will be highly
appreciated.
1. Are you interested in investing in?
2. Do you use these discounted cash flow methods for
evaluating startup projects?
3. What is your viewpoint regarding the usefulness
these two discounted cash flows methods for newly created ventures capital
budgeting?
|
Strongly disagree
|
Disagree
|
Neutral
|
Agree
|
Strongly agree
|
NPV method is sensible since it recognizes the time value of
money.
|
|
|
|
|
|
IRR technique is sensible as long as it takes into account the
time value of money.
|
|
|
|
|
|
NPV tool is preferable in case of mutually exclusive projects.
|
|
|
|
|
|
4. Between these two discounted cash flow techniques
of investment appraisal, what do you rather prefer?
5. Do you use these non-discounted cash flow methods
for evaluating projects?
6. Among the following non-discounted cash flow
techniques of investment appraisal, what do you think is more realistic in
judging capital budgeting proposal for start-ups?
7. When projects to evaluate are devoid of any
flexibility, to your mind what is the best analysis tool of investment
appraisal for startup companies?
8. What do you resort to in making flexible investment
decision for startup?
9. How do you rate Real options relating to making
better flexible capital expenditure decision for start-up organisations?
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
Real options provides us with a better adaptability in
the management of proposal
|
|
|
|
|
|
|
|
|
|
|
Other (please specify)
10. Out of the following, what is the most used
technique in appraising project in your organisation?