Business Model: Capital Budgeting, Equity

Valuation and Returns Attribution

FMRC Conference
Vanderbilt University

By
Thomas S. Y. Ho
Thomas Ho Company
tom.ho@thomasho.com

Sang Bin Lee

Hanyang University
May 19-20, 2005

Introduction

What is a business model?

Stoll dealers model

How does a firm generate profit?

A verbal plan or a written dream?
Business strategies
A provider of liquidity, compensated by the
spread
Equilibrium model and market structure

A business model

Assumptions
Financial modeling

Problem Statement

Use of the NPV capital budgeting approach in the

presence of fixed operating costs?
How should we compare the valuation of the firms
in a similar industry in terms of growth and cost
of capital with different operating leverage?
How do the financial leverage, operating leverage,
growth options affect the stock price?
A more general business model for valuation and
corporate financial decisions

Real Option Approach

Trigeorgis (1993a) values projects as

multiple real options on the underlying
asset value.
Botteron, Chesney and Gibson-Asner
(2003) uses barrier options to model the
flexibility in production and sales of
multinational enterprises under exchange
rate uncertainties.
Brennan and Schwartz model (1985) and
Fimpong and Whiting (1997) determine the
growth model of a mining firm.

Outline

Describe a business model of a retail

chain store
The model can be generalized
Impact of fixed costs on the capital
budgeting decisions
Building blocks of value for a firm
Impact of the change in revenue on
the stock price
Conclusions

Model Assumptions

Primitive firm follows a martingale

process
The fixed operating costs viewed as
perpetual debt, senior to
corporate liabilities.
The capital asset generates
perpetual revenues
A lattice framework

Primitive Firm Valuation

Cost of capital of the business depends on

the risk of gross returns on investment,
GRI
Revenues of the primitive firm depends on
the capital asset CA.
Use the risk neutral valuation valuation by
the change of measure.

VP (n, i )

GRI ( n, i ) CA

Terminal Conditions and the Free Cash

Flows

The perpetual debt of the fixed cost is risky

CF (n, i ) GRI ( n, i ) CA n, i FC

V p FC (T ) GRI (T , i ) CA(T , i ) FC ,

V (T , i ) Max

V p FC (T ) GRI (T , i ) (CA(T , i ) I ) FC I , 0
GRI (T , i ) CA T , i
Vp

Capital Investments and the Growth

Options

I is the investment outlay

CA(n 1, 2i ) CA(n 1, 2i 1) CA(n, i ) I (n, i )

Sales n, i I (n, i ) GRI n, i

Simulation Results on Capital

Budgeting Decisions

Given the fixed operating costs, some

positive NPV projects are not taken
The fixed operating cost is more significant
to the capital budgeting decision when the
firm may default on the fixed operating cost.
Implicit fixed cost =0 when the probability of
default =0. The traditional case
Extending Myers wealth transfer problem to
a contingent claim framework: distress or
start up scenarios, traditional method does
not apply

Top Down Optimal Investment Decision

vs the NPV Decisions

Debt Structure and Capital Budgeting

Decisions

Myers (1977)
Issuing

risky debt reduces the present

market value of a firm holding real
options by inducing a suboptimal
investment strategy or by forcing the
firm and its creditors to bear the costs
of avoiding the suboptimal strategy.
Corporate borrowing is inversely related
to the proportion of market value
accounted for by real options.

Fixed Cost Factor D

MPV = PV.D I >0

Implications

Valuation of a store front depending on

the retail chain store
Value of an acquisition depends of the
operating cost of the acquiring firm. Eg
communication companies, start ups
The fixed cost discount can be established
for each firm, based on the business
model
The curve can be used to determine the
optimal operating leverage

Relative Valuation of Similar Firms

A comparison of Target, Lowes, Wal-Mart,

Darden
Lowes: second largest US home
improvement chain, with 1090 stores
Darden: leading operator of casual dining
restaurants with 1,300 locations
Wal-Mart: world largest retailer, 5,200
stores
Target: 4th largest general merchandise
retailer, with 1000 stores

Inputs to the Model:Financial Ratios

Wal-Mart and its Comparables

High gross return on investments

4.8%
Significant fixed operating costs,
79% of the total asset
Low gross profit margin, 22%

Calibration Results

Calibration Results

Sales, gross profit margin, operating fixed

cost, growth rate are taken from the
financial statements
Calibrating the discount rate for the
business and the business risk (GRI)
volatility to the equity multiple, price
earnings, debt/ratio (market)
Market uses a lower business cost of
capital for Wal-Mart business, 7.02%,
with business volatility of 40%

Value Decomposition

Value Decomposition

Decomposition of Relative Valuation

Wal-Mart has the highest market to book

multiple, 7.5957: which are the main
value contributors?
The primitive firm value is the main value
contributor, with the business multiple,
16.66
The fixed-operating cost is quite high,
accounting for over 75% of the business
value
Growth option is 51%

Return Attribution for 1% Change in

Revenue

Equity Return Attribution

1% increase in the gross return on

investment leads to 1% rise in the
business value, by definition
1.07% and 0.134% increase in the equity
value attributed to the operating leverage
and financial leverage respectively
The growth option value increase is lower
than that of the business value, resulting
in a fall in 0.22%

Importance of the Business Model

Approach

Relate financial statements to firm

valuation
Combine analysis of the fixed operating
leverage and financial leverage on the
equity value and risks
A framework to analyze different industry
sectors
An approach to value credit risks
incorporating the business model

Conclusions

The method can be generalized to

other industries
The primitive firm and the option
approach provide a multi-period model
framework
Treatment of the fixed operating costs
in capital budgeting decisions
Broad range of applications of the value
decomposition and return attribution

Selected References

Stoll, Hans R. (1978) The Supply of

Dealer Services in Securities
Markets. Journal of Finance
(September)
Ho, Thomas S. Y. and Sang Bin Lee,
(2004a), The Oxford Guide to
Financial Modeling, Oxford
University Press, New York.