Business models: Applications to capital budgeting, equity value, and return attribution

Abstract

This chapter describes a business model in a contingent claim modeling framework. The model defines a “primitive firm” as the underlying risky asset of a firm. The firm′s revenue is generated from a fixed capital asset and the firm incurs both fixed operating costs and variable costs. In this context, the shareholders hold a retention option (paying the fixed operating costs) on the core capital asset with a series of growth options on capital investments. In this framework of two interacting options, we derive the firm value. The chapter then provides three applications of the business model. Firstly, the chapter determines the optimal capital budgeting decision in the presence of fixed operating costs and shows how the fixed operating cost should be accounted by in an NPV calculation. Secondly, the chapter determines the values of equity value, the growth option, and the retention option as the building blocks of primitive firm value. Using a sample of firms, the chapter illustrates a method in comparing the equity values of firms in the same business sector. Thirdly, the chapter relates the change in revenue to the change in equity value, showing how the combined operating leverage and financial leverage may affect the firm valuation and risks.