An exploration of tools of analysis commonly used by private equity in making investment decision

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.