Bluewolf Formation 2022 07/09/2022

CORPORATE ISSUERS
Chapter 2: Business Models, Risks & Capital Investments

Eugene Brandon BALA, PhD

BlueWolf
Business Intelligence www.bluewolf.eu
Formation www.bluewell.fr
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1. INTRODUCTION

Companies must take risks if they are to survive and prosper

The risk management function’s primary responsibility is to understand the portfolio of risks that the company is
currently taking and the risks it plans to take in the future.
It must decide whether the risks are acceptable and, if, they are not acceptable, what action should be taken.

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1. INTRODUCTION

Bala Series

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1. INTRODUCTION

Bala Series

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1. INTRODUCTION

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

 A successful firm must provide a product or service, find customers, deliver the product or service, and make a profit.
 The business model (it is not the financial plan) explains how a firm either does or proposes to do this.
 A business model should:
- Identify the firm’s potential customers, how they are acquired (and what cost) and how it maintain customer satisfaction.
- Describe the firm’s product or service, how it meets a need for its potential customers, and what differentiates its products
- Explain how the firm will sell its product or service (e.g., online, physical location, direct mail, trade shows, sales
representatives); whether they will sell direct to the buyers (direct sales) or use intermediaries such as wholesalers, retailers,
agents, or franchisees; and how will they deliver their product or service.
The answers to these questions comprise a firm’s channel strategy (B2B -business to business firms vs B2C - business
to consumer firms).
- Describe the key assets (including intangibles, key personnel), and suppliers of the firm.
- Explain its pricing strategy and why buyers will pay that price for their product, given the competitive landscape

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

 Value-based pricing refers to setting prices based on the value received (or perceived) by the buyer.

 Cost-based pricing refers to setting prices based on the costs of producing the firm’s good or service (plus a profit).

 Price discrimination refers to setting different prices for different customers or identifiable groups of customers.
Eg: tiered pricing (based on volume of purchases), dynamic pricing (depending on the time of day or day of the week – see
airlines), and auction pricing (e.g., eBay).

 A firm’s value proposition refers to how customers will value the characteristics of the product or service, given the
competing products and their prices. How the firm executes its value proposition is referred to as its value chain.
- A firm’s value chain comprises the assets of the firm and how the organization of the firm will add value and exploit the
firm’s competitive advantage.
- A value chain should not be confused with a firm’s supply chain, which includes every step in producing and delivering
its products, even those that other firms perform.

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

Porter's Value Chain

•Note, however, that companies compete with their network (upstream

and downstream) so the borders between these two conceptually
different notions are, actually, less obvious.

•A firm’s value proposition refers to how customers will value the characteristics of the product or service, given the competing products
and their prices.
•How the firm executes its value proposition is referred to as its value chain.

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

Le concept d’avantage concurrentiel (Porter) Stratégies génériques de domination (Porter)
Capacité de créer plus de valeur pour le client que ses compétiteurs!

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

• Providers of both debt and equity capital are concerned with firm risk and firm growth.
- Lenders like to see less uncertainty about earnings, cash flow, operating margins, and the like.
- Equity holders like earnings growth over time, but are also concerned with earnings volatility.

• Significant external factors that can affect business risk.

- Changes in economic conditions (e.g., economic growth, inflation and interest rates) typically affect all firms to some extent,
increasing firm risk.
- Changing demographics can affect the demand for some sectors’ and firms’ products, either positively or negatively.
- Political, legal, and regulatory change .

• Firm-specific (internal) factors:

- operating leverage (fixed vs variable costs)
- the stage of firm development: a start-up firm that requires large amounts of capital to grow has different financial needs
than a stable, mature firm.
- firm’s vulnerability to competition; more vulnerable firms have more business risk.

• A firm’s business model can have significant effects on its financing needs.

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

Types of business and financial risks for a company
 Macro risk refers to the risk (to operating profit) arising from economic, political, changes in exchange rates and legal
risk factors, as well as other risks that affect all businesses within a country or region or globally over time.
- The level of economic activity or growth may affect some companies strongly and we refer to such companies or
their industries as cyclical.
- Other companies, such as utilities and health care providers, are not affected strongly by economic cycles and we
refer to them as non-cyclical or defensive. .
 Business risk refers to the variability of operating income (EBIT) that arises from both firm-specific risk factors and
industry risk factors.
Industry risk factors include:
- Revenue and earnings cyclicality.
- Industry structure: Low concentration (many smaller firms) is associated with high competitive intensity.
- Competitive intensity: Higher competitive intensity in the industry typically reduces profitability.
- Competitive dynamics within the value chain: Profits are affected by actions of buyers, suppliers, and actual and
potential competitors.
- Long-term growth and demand expectations: An industry with increasing demand and high long-term growth
prospects is more attractive to investors, but may also attract more competition.
- Other industry risks are regulatory risks and other relevant external risks.

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1. KEY FEATURES AND TYPES OF BUSINESS MODELS

Firm-specific risk factors include:
 Competitive risks such as the erosion of an existing competitive advantage over time or the introduction of innovative
business models that disrupt the industry; execution risk, as some managements can find a way to fail with even the
best of business plans.
 Product market risk: For firms early in their life cycles, expectations of growth in demand may decrease over time,
consumer preferences may change, products may become obsolescent, and patents may expire. Firms with many
products typically face less product risk.
 Capital investment risk refers to investing firm assets in opportunities that do not produce returns above the firm’s cost
of capital. Many acquisitions (e.g., Time Warner) turn out to be quite ill-advised.
 ESG risk measures often focus on corporate governance risk, but the risk of running afoul of current expectations for
environmentally and socially progressive company policies can damage a company’s reputation and bottom line (or not,
e.g., Volkswagen).
 Business risk is increased by higher operating leverage that results from higher percentages of fixed costs, relative to
variable costs, in a firm’s cost structure. The effect of sales variability on operating income is magnified by higher
operating leverage.
 Financial risk refers to the increase in the variability of net income and cash flows that results from using debt in a
firm’s capital structure, which increases financial leverage. Financial leverage magnifies the effects of business risk on
profits.

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2. CAPITAL INVESTMENTS
• Capital budgeting is the allocation of funds to long-lived capital projects
 the capital allocation process.
• A capital project is a long-term investment in tangible assets.
• The principles and tools of the capital budgeting are applied in many different aspects of a business entity’s
decision making and in security valuation and portfolio management.
• A company’s capital budgeting process and prowess are important in valuing a company.

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CLASSIFYING PROJECTS

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3. BASIC PRINCIPLES OF CAPITAL BUDGETING

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COSTS: INCLUDE OR EXCLUDE?

• A sunk cost is a cost that has already occurred, so it cannot be part of the incremental cash flows of a capital
budgeting analysis.
• An opportunity cost is what would be earned on the next-best use of the assets.
• An incremental cash flow is the difference in a company’s cash flows with and without the project.
• An externality is an effect that the investment project has on something else, whether inside or outside of the
company.
 Cannibalization is an externality in which the investment reduces cash flows elsewhere in the company (e.g.,
takes sales from an existing company project).

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INDEPENDENT VS. MUTUALLY

EXCLUSIVE PROJECTS
• When evaluating more than one project at a time, it is important to identify whether the projects are independent or
mutually exclusive
 This makes a difference when selecting the tools to evaluate the projects.
• Independent projects are projects in which the acceptance of one project does not preclude the acceptance of
the other(s).
• Mutually exclusive projects are projects in which the acceptance of one project precludes the acceptance of
another or others.

• Capital projects may be sequenced, which means a project contains an option to invest in another project.
 Projects often have real options associated with them; so the company can choose to expand or abandon the
project, for example, after reviewing the performance of the initial capital project (hereafter)

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CAPITAL RATIONING
• Capital rationing is when the amount of expenditure for capital projects in a given period is limited.
• If the company has so many profitable projects that the initial expenditures in total would exceed the budget for
capital projects for the period, the company’s management must determine which of the projects to select.
• The objective is to maximize owners’ wealth, subject to the constraint on the capital budget.
 Capital rationing may result in the rejection of profitable projects.

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4. INVESTMENT DECISION CRITERIA

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NET PRESENT VALUE

The net present value is the present value of all incremental cash flows, discounted to the present, less the initial
outlay:
CFt
NPV = σn t=1 (1+r)t − Outlay (2-1)

Or, reflecting the outlay as CF0,

CFt
NPV = σn t=0 (1+r)t (2-2)

where
CFt = After-tax cash flow at time t
r = Required rate of return for the investment
Outlay = Investment cash flow at time zero

If NPV > 0:
•Invest: Capital project adds value
If NPV < 0:
•Do not invest: Capital project destroys value

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NET PRESENT VALUE

Example: A firm is considering a project with an initial

investment of $3,000,000. The project's cost of capital
is 12% and the expected cash flows are as follows:

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EXAMPLE: NPV
Consider the Hoofdstad Project, which requires an investment of $1 billion initially, with subsequent cash flows of
$200 million, $300 million, $400 million, and $500 million. We can characterize the project with the following end-
of-year cash flows:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

What is the net present value of the Hoofdstad Project if the required rate of return of this project is 5%?

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EXAMPLE: NPV
Time Line
0 1 2 3 4
| | | | |
| | | | |

–$1,000 $200 $300 $400 $500

Solving for the NPV:

$200 $300 $400 $500

NPV = –$1,000 + + + +
1 + 0.05 1 1 + 0.05 2 1 + 0.05 3 1 + 0.05 4

NPV = −$1,000 + $190.48 + $272.11 + $345.54 + $411.35

NPV = $219.47 million

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INTERNAL RATE OF RETURN

The internal rate of return is the rate of return on a project.
 The internal rate of return is the rate of return that results in NPV = 0.
CFt
σn
t=1 (1 + IRR)t − Outlay = 0 (2-3)

Or, reflecting the outlay as CF0,

CFt
σn
t=0 (1 + IRR)t = 0 (2-4)

If IRR > r (required rate of return):

•Invest: Capital project adds value
If IRR < r:
•Do not invest: Capital project destroys value

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INTERNAL RATE OF RETURN

Example:
A firm is considering a project with an initial investment
of $3,000,000. The firm's required return is 10% and
the expected cash flows are as follows:

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EXAMPLE: IRR
Consider the Hoofdstad Project that we used to demonstrate the NPV calculation:
Cash Flow
Period (millions)
0 –$1,000
1 200
2 300
3 400
4 500

The IRR is the rate that solves the following:

$200 $300 $400 $500

$0 = −$1,000 + + + +
1 2 3 4
1 + IRR 1 + IRR 1 + IRR 1 + IRR

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A NOTE ON SOLVING FOR IRR

• The IRR is the rate that causes the NPV to be equal to zero.
• The problem is that we cannot solve directly for IRR, but rather must either iterate (trying different values of IRR
until the NPV is zero) or use a financial calculator or spreadsheet program to solve for IRR.
• In this example, IRR = 12.826%:

$200 $300 $400 $500

$0 = −$1,000 + + + +
1 2 3 4
1 + 0.12826 1 + 0.12826 1 + 0.12826 1 + 0.12826

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NET PRESENT VALUE PROFILE

The net present value profile is the graphical illustration of the NPV of a project at different required rates of return.

The NPV profile intersects the

vertical axis at the sum of the
cash flows (i.e., 0% required
rate of return).
Net The NPV profile crosses the
Present horizontal axis at the project’s
Value internal rate of return.

Required Rate of Return

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NPV PROFILE: HOOFDSTAD CAPITAL PROJECT

$400
$500

$361
$323
$400

$287
$253
$219
$300

$188
$157
$127
NPV $200

$99
$72
(millions)

$46
$100

$20
–$4
–$28
–$50
–$72
–$93
–$114
$0

–$133
–$152
-$100

-$200
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Required Rate of Return

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RANKING CONFLICTS: NPV VS. IRR

 The NPV and IRR methods may rank projects differently.
 If projects are independent, accept if NPV > 0 produces the same result as when IRR > r.
 If projects are mutually exclusive, accept if NPV > 0 may produce a different result than when IRR > r.

 The source of the problem is different reinvestment rate assumptions

 Net present value: Reinvest cash flows at the required rate of return
 Internal rate of return: Reinvest cash flows at the internal rate of return

 The problem is evident when there are different patterns of cash flows or different scales of cash flows.

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EXAMPLE: RANKING CONFLICTS

Consider two mutually exclusive projects, Project P and Project Q:

End of Year Cash Flows

Year Project P Project Q

0 –100 –100
1 0 33
2 0 33
3 0 33
4 142 33

Which project is preferred and why?

Hint: It depends on the projects’ required rates of return.

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DECISION AT VARIOUS REQUIRED

RATES OF RETURN
$50 NPV of Project P NPV of Project Q

Project Project Decision $40

P Q
$30
NPV @ 0% $42 $32 Accept P, Reject Q
$20
NPV @ 4% $21 $20 Accept P, Reject Q
NPV @ 6% $12 $14 Reject P, Accept Q NPV $10
NPV @ 10% –$3 $5 Reject P, Accept Q $0
NPV @ 14% –$16 –$4 Reject P, Reject Q -$10
-$20
IRR 9.16% 12.11%
-$30
0% 2% 4% 6% 8% 10% 12% 14%
Required Rate of Return

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THE MULTIPLE IRR PROBLEM

• If cash flows change sign more than once during the life of the project (aka “unconventional”), there may be
more than one rate that can force the present value of the cash flows to be equal to zero.
 This scenario is called the “multiple IRR problem.”
 In other words, there is no unique IRR if the cash flows are nonconventional.

Example: €40
Consider the fluctuating capital project with the following end IRR = 34.249%
€20
of year cash flows, in millions - what is the IRR of this project?
€0
-€20
NPV IRR = 2.856%
Year Cash Flow -€40
(millions)
0 –€550 -€60
1 €490 -€80
2 €490
-€100
3 €490
4 –€940 -€120
0% 8% 16% 24% 32% 40% 48% 56% 64%
Required Rate of Return

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POPULARITY AND USAGE OF CAPITAL

BUDGETING METHODS
(Best measure)

(Alternative periods of cash)

(Inflows and outflows)

(Gives and idea of value creating) (The size of the project matters, ie IRR 50% over how
much?)

(More agressive assumptions)

Note: For independent projects NPV and IRR will and should produce the same conclusions!

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RELATIONSHIP AMONG NPV, COMPANY VALUE, AND

SHARE PRICE
• Capital allocation criterion and analysis are essential tools for corporate managers.
• Initial posit:
The value of a company is the value of its existing investments plus the net present values of all its future
investments, accounting for any externalities.
• Second posit:
If the company can invest elsewhere and earn a return of r or if the company can repay its sources of capital and
save a cost of r, then r is the company’s opportunity cost of funds.
- If the company can make an investment that earns more than its opportunity cost of funds, then the investment is creating
value for the company and corresponding wealth for shareholders and should be undertaken.
- Similarly, if the investment earns less than the company’s opportunity cost of funds, the investment decreases value in the
company, leaving shareholders less wealthy, and should not be undertaken.

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RELATIONSHIP AMONG NPV, COMPANY VALUE, AND

SHARE PRICE
• The return on invested capital (ROIC) is one measure of the profitability (in the aggregate) of a company
relative to the amount of capital invested by the equity and debtholders.
- ROIC reflects how effectively a company’s management is able to convert capital into profits. The ratio is calculated by
dividing the after-tax net profit by the average book value of invested capital (common, preferred, and debt).

• The ROIC measure is often compared with the associated cost of capital (COC),the required return used in the
NPV calculation and the company’s associated cost of funds.
- If the ROIC measure is higher than the COC, the company is generating a higher return for investors compared with the
required return, thereby increasing the firm’s value for shareholders.
- The inverse is true if the COC is higher than the ROIC.

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RELATIONSHIP AMONG NPV,

COMPANY VALUE & SHARE PRICE
• If a company invests in a positive NPV project, the expectation is that shareholder wealth will be increased as well
as the company’s stock value.
• The market value of the company would be expected to increase by the NPV amount. The stock price would also
be expected to increase by the NPV per share, i.e., the NPV divided by the number of shares outstanding.
• The effect of a project’s NPV is, however, more complicated than this:
- if an analyst learns that a company intends to undertake an investment, the impact of the investment on the company’s stock
price will depend on whether or not the investment’s profitability is more or less than expected. For example, a company’s
project may have a positive NPV, but if the project’s profitability is less than analysts expect it to be, then the company’s stock
price might fall.
- It is also possible that news of a project having a positive NPV sends a positive signal to the markets, causing market
players to expect that other profitable projects may be underway. This may serve to increase the company’s stock price.
• Management’s capital budgeting processes may indicate the extent to which management embraces the goal of
shareholder wealth maximization and its effectiveness in pursuing that goal. This is extremely important to both
shareholders and analysts and may influence company valuation and share price.

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RELATIONSHIP AMONG NPV, COMPANY VALUE, AND

SHARE PRICE
• Although the capital allocation model accommodates the effects of inflation, inflation complicates the capital
allocation process (and the operations of a business, in general).
• Inflation does not affect all revenues and costs uniformly.
• Companies may choose to do the analysis in either nominal or real terms (more often nominal)
 The cash flows and discount rate used by the company should both be nominal or both be real
• Inflation reduces the value of depreciation tax savings to the company (unless the tax system adjusts depreciation
for inflation), effectively increasing its real taxes.
• The effect of expected inflation is captured in the discounted cash flow analysis:
- If inflation is higher than expected, the profitability of the investment is correspondingly lower than expected, inflation
essentially shifting wealth from the taxpayer (i.e., company) to the government.
- Conversely, lower-than-expected inflation reduces real taxes for the company (the depreciation tax shelters are more
valuable than expected) and results in higher-than-expected profitability of the investment and a corresponding wealth
increase for the company.

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RELATIONSHIP AMONG NPV, COMPANY VALUE, AND

SHARE PRICE
Example
Freitag Corporation is investing €600 million in distribution facilities. The present value of the future after-tax cash flows is
estimated to be €850 million.
Freitag has 200 million outstanding shares with a current market price of €32.00 /share. This investment is new information, and it
is independent of other expectations about the company.
What should be the investment’s effect on the value of the company and the stock price?

Solution:
The NPV of the investment is €850 million − €600 million = €250 million.
The total market value of the company prior to the investment is €32.00 × 200 million shares = €6,400 million.
The value of the company should increase by €250 million, to €6,650 million.
The price per share should increase by the NPV per share, or €250 million/200 million shares = €1.25 per share.
The share price should increase from €32.00 to €33.25.

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REAL OPTIONS
Real options are options that allow companies to make decisions in the future that alter the value of capital
investment decisions made today, and are an important piece of the value in many capital investments.
 Timing Options: Project sequencing options allow the company to defer the decision to invest in a future investment until
the outcome of some or all of a current investment is known.
 Sizing Options: If after investing the company can abandon the investment if the financial results are disappointing, it has an
abandonment option or, conversely, if the company can make additional investments when future financial results are strong,
the company has a growth option or an expansion option.
- When estimating the cash flows from an expansion, the analyst must also be wary of cannibalization.
 Flexibility Options: Once an investment is made, operational flexibilities besides abandonment or expansion may be
available. For example, suppose demand exceeds capacity, management may be able to exercise a price-setting option.
 By increasing prices, the company could benefit from the excess demand, which it cannot do by increasing production.
what is forecast. - There are also production-flexibility options, which offer the operational flexibility to alter production when
demand varies from
 Fundamental Options: in other cases, the whole investment is essentially an option, the payoffs from the investment are
contingent on an underlying asset, just like most financial options.
 For example, the value of an oil well or refinery investment is contingent on the price of oil. If oil prices were low, you likely
would not choose to drill a well. If oil prices were high, you would go ahead and drill.
- Many R&D (research and development) projects also look like options.

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REAL OPTIONS
Management can take the following common sense approaches to real option analysis:
1 Use DCF (discounted cash flow) analysis without considering options.
If the NPV is positive without considering real options and the project has real options that would simply add more value, it is
unnecessary to evaluate the options. Management should simply undertake the investment.

2 Consider the Project NPV = NPV (based on DCF alone) – Cost of options + Value of options.
Calculate the NPV based on expected cash flows. Then simply add the value associated with real options less their
incremental cost.

3 Use decision trees.

Although they are not as conceptually sound as option pricing models, decision trees can capture the essence of many
sequential decision-making problems for companies.

4 Use option pricing models.

In carrying out capital allocation, management must consider
(1)a variety of real options that investments may possess and
(2) a decision about how to reasonably value these options.

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REAL OPTIONS
• Production-Flexibility Option
Auvergne AquaFarms has estimated the NPV of the expected cash flows from a new processing plant to be –€0.40 million.
Auvergne is evaluating an incremental investment of €0.30 million that would give management the flexibility to switch among
coal, natural gas, and oil as energy sources.
The original plant relied only on coal. The option to switch to cheaper sources of energy when they are available has an
estimated value of €1.20 million.
What is the value of the new processing plant including this real option to use alternative energy sources?

Solution:
The NPV, including the real option, should be
Project NPV = NPV (based on DCF alone) – Cost of options + Value of options.
Project NPV = –0.40 million – 0.30 million + 1.20 million = €0.50 million.
Without the flexibility offered by the real option, the plant is unprofitable. The real option to adapt to cheaper energy sources
adds enough to the value of this investment to give it a positive NPV. The company should undertake the investment, which
would add to its value.

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COMMON CAPITAL ALLOCATION PITFALLS

• Not incorporating economic responses into the investment analysis.
• Misusing capital allocation templates
• Pushing pet projects
• Basing investment decisions on EPS, net income, or ROE:
Paying too much attention to ST accounting numbers can result in choosing investments that are not in the LT interests of its
shareholders.
• Using IRR to make investment decisions for investment opportunities that are mutually exclusive
• Incorrectly accounting for cash flows
• Over- or underestimating overhead costs:
-The cost of an investment may include the overhead it generates for items hard to estimate such as as management time, information
technology support, financial systems, and other support. .
• Not using the appropriate risk-adjusted discount rate:
- The required rate of return for an investment should be based on its risk. If the company is financing an investment specifically with
debt (or with equity), the investment’s required rate of return - not the company’s cost of debt (or cost of equity) - should still be used.
- Similarly, a high-risk investment being considered should be discounted not at the company’s overall cost of capital but at the
investment’s required rate of return.
• Overspending and underspending the capital allocation:
• Incorrectly handling sunk costs and opportunity costs
- Not identifying the economic alternatives (real and financial) that are the opportunity costs is probably the biggest failure by
companies in their analyses.

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QUESTIONS
• Check separate handout

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