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

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.