Ameritrade is formed in 1971, and is a pioneer in the deep-discount brokerage sector. In march 1997, Ameritrade raised $22. 5 million in an initial public offering. Management at Ameritrade is considering substantial investments in technology and advertising, but is unsure of the appropriate cost of capital. Estimating the cost of capital 1. Since we do not have the beta for Ameritrade, we need to find comparable firms for which we could compute the betas. There are several candidates in the case. Discuss which firms are most appropriate.

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Thus, the proportion of the revenue a firm earns from transactions and interest (brokerage activities) has something to do with the risk. Thus, to find the firms of comparable risks, we may take a look at the brokerage revenue of the brokerage firms. From exhibit 1, 90 % of the total net revenue of Ameritrade is from brokerage activities. See Exhibit 4. Which companies would be good candidate as the “comparable firms”? Considering the brokerage revenue percentage, Charles Schwab, E*trade, Quick & Reilly and Waterhouse Investor appear to be the comparable firms.

2. Find the risk-free rate.

To determine the risk free rate, match the economic life of the project. Considering a significant investment in technology and the goal of the company to be the largest brokerage firm, the project that we are considering is a long term project. Thus, we may use the prevailing yield of 10-year bonds. (See Exhibit 3) Risk Free rate= 6. 34% 3. Find the market-risk premium We use the difference between the historical large company stocks and long term bonds. The case offers two tables for the historical averages, one for the average between 1950-1996, and the other for the average between 1929-1996.

If there is no significant structural change in the market risk premium, the longer data produces more accurate estimate. However, if there is a significant structural change, more recent data may give better estimate of the risk premium. We are not sure which one is better. So let us use both case. Risk premium (1950-1996)=14. 0% – 6. 0%=8% Risk Premium (1929-1996)=12. 7% – 5. 5%=7. 2% 4. Compute the equity betas for comparable firms. Then based on the results, compute the asset beta for each firm. Exhibit 5 shows the stock prices for the comparable firms. The return is computed as

Return = (Pt+1 – Pt + Divt+1)/Pt As can be seen, there have been some incidences of stock split. 3 for 2 means that 2 shares are split into 3 shares. Now, using the VM NYSE (Value weighted NYSE index) as the proxy for the market return, compute equity betas for each company. Use the past 5 years of data to compute the beta. After computing equity beta, using the Debt-value ratio in Exhibit 4, unlever the equity beta, (i. e. , compute the asset beta from equity beta). 5. Taking the average of the asset betas for the comparable firms, and use this as the estimate for the asset beta for Ameritrade.

Estimate the asset beta for the Ameritrade The compute the cost of capital for Ameritrade. The estimated cost of capital should be around 20%. Relatively high cost of capital reflect the fact that most of the revenue is highly sensitive to the stock market. 6. Use the estimated asset beta, compute the cost of capital. 1. Primary Sources of Revenue a) Transaction – commission, clearing fees and payment for order flow b) Interest – charging customers on debt balances and investment of customers’ cash segregated in compliance with federal regulations in short-term securities. 2.

How risky are these cash flows? How related to stock market? Virtually all revenues are directly linked to the stock market and in a downturn, investors decrease their trading activity and borrowing so revenues decline substantially. 3. How can CAPM be used to estimate the cost of capital for real investment decision? CAPM can be applied to any security as well as a real investment. We need to find an appropriate risk free investment as well as the Beta of our investment with the industry investment and the risk premium that investors demand over the industry premium. CAPM = rf + B x (rm –rf) . What is the estimate for the risk free rate that should be employed in calculating the cost of capital for Ameritrade? Since the project involves substantial investments in technology and advertising and the cash flows are projected in the future we can assume that it’s a long term investment so we should use long term rates and we should use current rates, not historical rates. I’ll use a 10 year time horizon so the current 10 year interest rate is: 6. 34% 5. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade?

The market risk premium for Ameritrade we should use the difference between the returns on small stocks (Ameritrade has a market capitalisation as of August 29, 1997 of $273,127,000 and the returns on long term (20 years) government bonds: We use the more recent historical data as the first one includes war periods and is less modern and therefore less consistent with new technology. Risk premium (1950-1996) = 17. 8% – 6. 0% = 11. 8% 6. What do we use for Beta? To compute betas we need the periodic returns of comparable companies and the returns of the value weighted market index as a whole.

We regress both returns and get the slope of the line which is our Beta. We should use estimates for the last 5 years. [pic] [pic] [pic] 7. What comparable firms can we use as benchmarks for Ameritrade’s risk? Considering the brokerage revenue percentage, Charles Schwab, E*trade, Quick & Reilly and Waterhouse Investor appear to be the comparable firms. [pic] [pic] 8. How to estimate the asset betas of comparables? [pic] [pic] [pic] [pic] We eliminate E*Trade due to lack of long term data : only use WIS, Charles Schwab and Quick & Reilly as comparables. 9. What is the cost of capital? [pic] [pic] [pic] [pic][pic]