Ameritrade: Cost of Capital What factors should Ameritrade Management consider when evaluating the proposed advertising program and technology upgrades? Why? When considering the proposed advertising program and technology upgrades, we have to ensure that the project will likely add value to the company, so we need to consider the return on investment versus the cost of capital. If the return on investment, measured by the net present value and internal rate of return, exceeds the cost of capital, the investment should be taken.
In addition, we need to evaluate the project’s systematic risk (beta), which includes risks that are not unique to a particular project and not easily manageable by a project team at a given point in time. How can the C. A. P. M be used to estimate the cost of capital for a real (not financial) investment decision? C. A. P. M describes the relationship between risk and expected return of the investment.
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In order to use the CAPM to estimate the cost of capital for this investment decision, we need to identify comparable companies, extract their unlevered beta (since we don’t have the information for Ameritrade), determine the appropriate manner to average them, and apply the resulting beta to the investment’s CAPM. We use an unlevered beta of comparable companies because every company has a unique capital structure and leverage has no affect on the risk or return of a firm’s assets.
What is the estimate of the risk-free rate that should be employed in calculating the cost of capital for Ameritrade? Because Ameritrade is going to make a substantial investment in technology and the objective of the company is to become the largest discount brokerage firm, we are considering this to be a long term project. To match the economic life of the project, we will use the prevailing yield of long term bonds. Yield to maturity of 30-Year Bonds is 6. 61% So the estimate of risk-free rate that should be employed in calculating the cost of capital for Ameritrade should be 6. 1% What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade? We should use the difference between the historical large company stock and the long term bonds as the appropriate market risk premium. There are two historic data tables available, one is 1950-1996, and the other is 1929-1996. As we mentioned before, since the economic life of Ameritrade is comparable to long-term bond, the Average Annual Return of Annual bond should be employed as the risk free rate.
As a deep discount brokerage firm, Ameritrade’s revenue is directly linked to the stock market, so the Average Annual Return for Large Company Stock Market (S 500) is the most appropriate representative of stock market return. 1950-1996 Risk Premium= R_m-R_f=14. 0%-6. 0%=8. 0% 1929-1996 Risk Premium= R_m-R_f=12. 7%-5. 5%=7. 2% We decided to use the 1950 to 1996 time frame since we believe that the market returns in this time frame better reflect the current market and economic conditions.
In principal, what are the steps for computing the asset beta in the C. A. P. M for purposes of calculating the cost of capital for a project? Assuming no tax involved, to compute the asset beta in the C. A. P. M for purpose of calculating the cost of capital for a project, we need to take the following steps. Step 1: find the weighted average Beta of Equity for industry Step 2: find the average industry leverage W_debt= D/(D+E ) and W_equity= E/(D+E ) Step 3: find the “unlevered” asset beta of industry, assuming beta of debt=0 ? asset=? _equity/((1+Debt/Equity)) Step 4: C. A. P. M=R_f+? _a (R_m-R_f) Ameritrade does not have a beta estimate as the firm has been publicly trade for only a short time period. Exhibit 4 provides various choices of comparable firms. What comparable firms do you recommend as the appropriate benchmark for evaluating the risk of Ameritrade’s planned advertising and technology investments?
Because Ameritrade is a deep discount broker, it earns most of its revenue from brokerage transactions and interest income while full service brokers have diverse source of revenue, which usually includes consistent management fees. From Exhibit 1, 90 % of the total net revenue of Ameritrade is from brokerage activities. Taking the brokerage revenue percentage into consideration, Charles Schwab, E*TRADE, Quick& Reilly and Waterhouse investor these deep discount brokerage firms could be used as comparable firms.
Charles SchwabE*TradeQuick & Reilly GroupWaterhouse Investor Brokerage Rev (%)82%95%81%99% *However, since E*trade historical data is so short and it is unclear if it should be valued as a technological or brokerage company, we decided to not include them in our calculations. Using the stock price and returns data in Exhibits 4 and 5 (or, if you wish, other equivalent data sources), and the capital structure information in Exhibit 3, calculate the asset betas for the comparable firms.
What is the appropriate estimation period to compile the data? We used the following formula to derive the return of our comparable firms: By using the company return and the Value Weighted Returns of the Market, we derived the companies’ levered equity betas and then unlevered them. ?_(U Charles Schwab)=1. 28246 ?_(U Quick)=2. 3388 ?_(U Waterhouse Investors)=0. 4221 Since we did not have any data to establish appropriate weights, we used the arithmetic mean to derive a beta for Ameritrade. Average Arithmetic ? U=1. 3478 We use the time period of year 1987 to year 1996 since it was the longest time frame for which all three of comparable firms had data available. How should Joe Ricketts, the CEO of Ameritrade, view the cost of capital estimate you have calculated? Cost of Capital= 6. 61%+1. 3478*(8. 0%) =17. 392% While the cost of capital we generated could be used as a reference, Joe rickets ought to realize that there are some potential problems embedded with the cost of capital estimation that our team have calculated.
Data from comparable firms are historical data and may not reflect the future results. Since this a new development in the industry, the risk associated with this investment may not coincide with the performance of the industry. And therefore, using the historical betas of comparable firms to derive the appropriate beta for Ameritrade may not be the appropriate way to evaluate this investment risk. The discount rate we calculated is based on the company’s point of view. Investors may have a different view of the risks involved and may apply a different discount rate.