1. Description

Ameritrade, in 1997, wanted to expand their customer base and improve their overall

competitive position in the deep-discount brokerage industry. In order to do so, their Chairman

and CEO, Joe Ricketts, wanted to invest in technology and, correspondingly, marketing in order

to attract more customers. Ameritrade wanted to position themselves apart from their

competition by drastically reducing commissions. In order to do this and remain profitable, they

will need to increase their client base.

3. Ameritrade has a short history of trading, so its equity beta cannot be computed precisely using its own historical data. Exhibit 4 provides some choices for comparable firms. Which of these firms do you think are appropriate to use as comparables to determine the beta of Ameritrade’s planned advertising and technology investments? Why?

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. 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.

The CAPM is an important measure when it comes to real investment decisions because it

provides a basis of comparison for financial decisions. The return on a project must be greater

than what the firm can earn by investing an equivalent amount of money in financial

investments.

How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real

(not financial) investment decision? The CAPM states that an investor’s expected rate of return

equals the risk free rate plus the market risk premium weighted by beta. Managers are expected

to make decisions that add to shareholder value. If the project does not provide a return greater

than the investor’s expected rate of return, the project should not be undertaken. Additionally,

when you use unlevered beta (asset beta) you reflect on the project risk not the company’s

financing risk.

1. What factors should Ameritrade management consider when evaluating the proposed

advertising program and technology upgrades? Why?

a. Opportunity Cost – Will Ameritrade benefit from spending money on advertising and

technology upgrades more than the next best alternative and more than reinvesting the

money.

b. Debt-to-Equity Ratio – If this ratio is high then Ameritrade may be able to generate more

equity and increase earnings by more than the cost then the shareholders will benefit

because more earnings will be spread amongst shareholders.

c. Future cash flows – If futures cash flows are high and Ameritrade is able to remain cash

positive, and then they will have more protection against market volatility.

d. Return on Investment or Equity – this will tell Ameritrade if the proposed upgrades and

additional advertising will generate earnings growth and by how much (additional money

for shareholders as well).

COST OF CAPITAL = OPPORTUNITY COST

HOW ? CAPM results can be compared to the expected rates of return that investor can possibly

earn in other investments with similar risks

Case analysis "Cost of Capital at Ameritrade"

Cost of capital refers to the maximum rate of return a company must earn from its investments,

so that the market values of the company’s equity shares do not go down.

If we use historical average of total annual return of small CAP stocks as our market risk,

we also have to use historical risk-free rate do determine the risk premium. For the

CAPM method, the historical average return on market should never be used with the

current risk-free rate.

DATA: Historical Rf = 6.0% (Long Term Bonds b)

But current Rf is –year bonds. So this approach has current Rf and then historical in

riskpremium.

We don’t have reliable estimate where stock market will move in future. So we are using long

term historical spreadsheets for estimate & large stock than small stocks because they are more

closer to proper estimate of market

We are considering all values after Second World War because after that laws became stable in

U.S.

U.S. government securities rate = 6.69% (20 years bond, Exhibit 3)

Average annual return for Large company stocks = 14 % (Exhibit 3)

So Risk premium for Ameritrade

= 14 % - 6.69 % =7.31 %

The risk free rate that should be used when calculating the cost of capital, using the CAPM

would be 6.22%, because this is the 5-year bond annualized yield to maturity. The 5-year bond

give us an accurate look for use in the CAPM, because the technological venture that they are

about to go into need to be renewed continuously.

To determine the risk free rate, I would use to match the economic life of the project, counting

that yes is a significant investment in technology and the goal of the company to be the largest

brokerage firm, however technology needs to be renovated every couple of years, and

advertising too, the project in considering I Would take it as a short t term project. Thus, I would

use the prevailing yield of 5-year bonds from exhibit #3 where the Risk Free rate= 6.22%

Ameritrade should use a 6.10% risk free rate when calculating its cost of capital. This is the

average of the 20 year bond annualized yield to maturity (on August 31, 1997) and the long

term historical average annual return (from 1929 ? 1996). The long term bond return was used

because it provides an accurate average annual return since it reflects many years. The 20 year

bond as of August 31, 1997 was used because it is the current yield to maturity. They were

averaged in order to get a rate that would reflect current rates, but also be more reliable since it

involves data from many years.

What is the estimate of the risk-free rate and the market risk premium that should be employed in

calculating the cost of capital for Ameritrade?

From Exhibit 3,

The risk-free rate = 6.61% (30-year bonds)

The risk premium is equal to the annual return on common stocks reduces that on government

stocks.

The risk premium (1950-1996)= 14.0% (large company stocks)- 6% (the annual return on government

stocks)= 8%

The risk premium (1929-1996)= 12.7% (large company stocks)- 5.5% (the annual return on

government stocks)= 7.2%

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%