Business%20Model:%20Capital%20Budgeting,%20Equity%20Valuation%20and%20Returns%20Attribution%20FMRC%20Conference%20Vanderbilt%20University

1
Business Model Capital Budgeting, Equity
Valuation and Returns AttributionFMRC
Conference Vanderbilt University

• By
• Thomas S. Y. Ho
• Thomas Ho Company
• tom.ho_at_thomasho.com
• Sang Bin Lee
• Hanyang University
• May 19-20, 2005

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Introduction

• What is a business model?
• How does a firm generate profit?
• A verbal plan or a written dream?
• Stoll dealers model
• Business strategies
• A provider of liquidity, compensated by the
  spread
• Equilibrium model and market structure
• A business model
• Assumptions
• Financial modeling

3
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

4
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.

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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

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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

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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.

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Terminal Conditions and the Free Cash Flows

• The perpetual debt of the fixed cost is risky

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Capital Investments and the Growth Options

• I is the investment outlay

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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

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Top Down Optimal Investment Decision vs the NPV
Decisions
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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.

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Fixed Cost Factor DMPV PV.D I gt0
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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

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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

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Inputs to the ModelFinancial Ratios
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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

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Calibration Results
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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

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Value Decomposition
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Value Decomposition
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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

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Return Attribution for 1 Change in Revenue
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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

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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

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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

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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.