1. 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

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 D MPV = 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: 4 th 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.  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

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.