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

1. 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

2. 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.

5. 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

6. 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

7. 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.

8. Terminal Conditions and the Free Cash Flows • The “perpetual debt” of the fixed cost is risky

9. Capital Investments and the Growth Options • I is the investment outlay

10. 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

11. Top Down Optimal Investment Decision vs the NPV Decisions

12. 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.

13. Fixed Cost Factor DMPV = PV.D –I >0

14. 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

15. 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

16. Inputs to the Model:Financial Ratios

17. 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%

18. Calibration Results

19. 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%

20. Value Decomposition

21. Value Decomposition

22. 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%

23. Return Attribution for 1% Change in Revenue

24. 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%

25. 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

26. 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

27. 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.