Date post: | 24-Dec-2015 |
Category: |
Documents |
Upload: | diana-booth |
View: | 248 times |
Download: | 0 times |
Business Model: Capital Budgeting, Equity Valuation and Returns AttributionFMRC Conference Vanderbilt University
ByThomas S. Y. HoThomas Ho [email protected]
Sang Bin LeeHanyang UniversityMay 19-20, 2005
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
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.
( , )( , )P
GRI n i CAV n i
Terminal Conditions and the Free Cash Flows
The “perpetual debt” of the fixed cost is risky
( ) ( , ) ( , ) ,( , )
( ) ( , ) ( ( , ) ) 0,
p
p
V FC T GRI T i CA T i FCV T i Max
V FC T GRI T i CA T i I FC I
( , ) ,p
GRI T i CA T iV
( , ) ( , ) ,CF n i GRI n i CA n i FC
Capital Investments and the Growth Options
I is the investment outlay
( 1,2 ) ( 1,2 1) ( , ) ( , )CA n i CA n i 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 Myer’s 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 DMPV = PV.D –I >0
Fixed Cost Factor
0
0.2
0.4
0.6
0.8
1
1.2
-100 0 100 200 300 400
%change in Firm Value
dis
cou
nt
fact
or
Series1
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, 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
Inputs to the Model:Financial Ratios
Target Lowe's Wal-Mart Darden
GRI 2.9769 2.5807 4.8082 2.2823
Gross profit margin(m) 0.3169 0.2880 0.2274 0.2222
Fixed cost/total asset(FC/CA) 0.6564 0.4684 0.7907 0.2293
Capital investment (I/CA) 0.1563 0.2381 0.1530 0.1130
Leverage(CA/E) 1.7218 1.2965 1.3033 1.7190
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
Reported Estimated Reported Estimated Reported Estimated Reported Estimated
S/E 5.1009 5.3231 5.3543 5.4717 7.6893 7.8420 3.1623 3.2699
S/V 0.8321 0.8500 0.9054 0.9089 0.9351 0.9363 0.8634 0.8779
Cost of capital
Volatility 0.2776
0.0821
0.3908
Darden
0.3149
0.1036
0.3772
0.0860 0.0702
Target Lowe's Wal-Mart
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
Target Lowe's Wal-Mart Darden
Mkt equity S 41840 36520 275270 3385
Primitive firm V* 161313 84728 762427 9612
Mkt value fixed cost F 129766 60269 568304 6438
Growth option G 17674 15722 99878 682
Mkt value of debt D 7382 3661 18732 471
Book equity E 7860 6674 35102 1035
Estimated S/E 5.3231 5.4717 7.8420 3.2699
Value Decomposition
Target Lowe's Wal-Mart Darden
Vp/CA 11.9200 9.7913 16.6651 5.4017
Vfc /Vp 0.1956 0.2887 0.2546 0.3302
V/Vfc 1.5602 1.6428 1.5145 1.2148
CA/E 1.7218 1.2965 1.3033 1.7190
S/V 0.8500 0.9089 0.9363 0.8779
S/E 5.3231 5.4717 7.8420 3.2699
Book Value(E/shares) 8.7062 8.6044 7.8004 5.8818
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
Target Lowe's Wal-Mart Darden
ln(Vp/CA) 0.0100 0.0100 0.0100 0.0100
ln(Vfc /Vp) 0.0138 0.0085 0.0107 0.0070
ln(V/Vfc) -0.0022 -0.0014 -0.0022 0.0003
ln(S/V) 0.0027 0.0010 0.0013 0.0016
ln(CA/E) 0.0000 0.0000 0.0000 0.0000
ln(Book value(E/shares)) 0.0000 0.0000 0.0000 0.0000
ln(Stock price) 0.0244 0.0180 0.0197 0.0189
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.