This paper 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. The value of the firm is derived.
The paper then provides three applications of the business model. Firstly, the paper determines the optimal capital budgeting decision in the presence of fixed operating costs, and show how the fixed operating cost should be accounted by in an NPV calculation. Secondly, the paper determines the values of equity value, the growth option, the retention option as the building blocks of primitive firm value. Using a sample of firms, the paper illustrates a method in comparing the equity values of firms in the same business sector. Thirdly, the paper 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.
