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Business Model: Capital Budgeting, Equity Valuation and Returns Attribution FMRC Conference Vanderbilt University PowerPoint Presentation
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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?

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Business Model: Capital Budgeting, Equity Valuation and Returns AttributionFMRC 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
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
problem statement
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
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
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
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
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.
terminal conditions and the free cash flows
Terminal Conditions and the Free Cash Flows
  • The “perpetual debt” of the fixed cost is risky
simulation results on capital budgeting decisions
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 Myer’s wealth transfer problem to a contingent claim framework: distress or start up scenarios, traditional method does not apply
debt structure and capital budgeting 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.
implications
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
Relative Valuation of Similar Firms
  • A comparison of Target, Lowe’s, Wal-Mart, Darden
  • Lowe’s: 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
wal mart and its comparables
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 results19
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%
decomposition of relative valuation
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%
equity return attribution
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
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
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
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.