Questions and Analysis
When evaluating the proposed advertising program and technology upgrades, Ameritrade management should consider what factors and why.
- 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.
- 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.
- 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.
- 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).
The utilization of the Capital Asset Pricing Model (CAPM) for estimating the cost of capital in real investment decisions involves adding the risk-free rate to the market risk premium, which is then weighted by beta.
Managers have the responsibility of enhancing shareholder value by making decisions. If a project fails to yield a higher return than what investors anticipate, it should not be pursued. Moreover, when considering unlevered beta (or asset beta), the emphasis is on assessing the project’s risk rather than the company’s financial risk.
When calculating the cost of capital with the CAPM, it is vital to determine the correct risk-free rate. In this case, the suitable risk-free rate to use is 6.2%, which is obtained from the annualized yield to maturity of a 5-year bond. Using a 5-year bond provides an accurate estimate for CAPM goals, particularly for technology ventures that require constant improvements and advancements. After considering all factors, selecting the 6.2% risk-free rate would be the most appropriate choice for CAPM objectives.
The estimate of risk premium on the market that should be used in the CAPM is 11.8%. Knowing that Ameritrade is considered a small company and considering the historical averages from 1950-1996 as more accurate than those from 1929-1996 due to the impact of the Great Depression and World War II, a more precise estimation of the risk premium can be made. To calculate this figure, simply subtract the rates given in Exhibit 3 (17.8% – 6.0%), resulting in a rate of 11.8%. Furthermore, Ameritrade does not currently have a beta estimate as the firm has only been publicly traded for a short period mentioned in the case. Exhibit 4 provides several options of comparable firms.
Which firms would you suggest as the suitable reference point for assessing the risk of Ameritrade’s intended advertising and technology investments? Kindly explain. Our initial step is to determine Ameritrade’s nature, which is a Deep Discount Brokerage Firm. Although some may view its line of business as more aligned with internet firms, the primary customer base and revenue stream derive from exchange fees for managing securities transactions. Hence, we believe it would be more appropriate to make a consistent comparison with fellow discount brokerage firms in the long run.
There is insufficient data provided in the case study to calculate risk for internet companies. If Ameritrade successfully implements its online access strategy, other competing firms are likely to do the same and the industry will adapt to the changing market. The technological aspect of Ameritrade’s business is crucial for its execution, but it is not the core of the business itself. The website does not generate revenue from advertising and its service offerings are not significantly different from its competitors; instead, it focuses on convenience.
Although E*trade lacks sufficient historical data for benchmarking Ameritrade, it is still considered an ideal firm for comparison. In evaluating Ameritrade’s investment risk, other discount brokerage firms such as Charles Schwab, Quick & Reilly Group, and Waterhouse Investor Services will also be taken into consideration.
Using the data in Exhibits 3, 4, 5 and 6, the asset betas for comparable firms were calculated as follows:
- Charles Schwab: 2.09
- Quick & Reilly: 1.70
- Waterhouse: 1.98
The data for Charles Schwab and Quick & Reilly was used from January 1992 through August 1997.
Waterhouse data from January 1992 through September 1996 was utilized in the analysis. The regression analysis for each firm provided the asset betas, which were calculated using the formula: (Unlevering Betas) ? assets = ? debt (D / V) + ? equity (E / V). In this case, the debt was assumed to be 0, and the debt and equity ratios were obtained from Exhibit 4. The firms included in the analysis were Charles Schwab, Quick & Reilly Group, and Waterhouse.
What is your estimate of the cost of capital for Ameritrade’s planned investment? Please provide all of your assumptions.
Determining the Asset Beta: (Unlevering Betas)
Assets = Debt(D/V) + Equity (E/V)
i. Since there is no Beta for Ameritrade, we will use comparable firms as a basis for our comparison. We will only consider discount brokerage firms (Exhibit 4). These firms include Charles Schwab, E*trade, Quick & Reilly, and Waterhouse Investor. Out of these four firms, there is not sufficient data for E*Trade.
- Charles Schwab Asset Beta (last 5 years 1992 – 1997 regression) = 2. 09
- Waterhouse Investor Asset Beta (last 5 yrs ‘92 – ‘97 regression) = 1. 8
- Quick & Reilly Asset Beta (last 5 yrs ‘92 – ‘97 regression) = 1. 7
- Ameritrade Beta = (2. 09 + 1. 98 + 1. 7) / 3 = 1. 923 f.
Risk-free rate, based on historical long-term bonds, is 6.0%. The risk-free rate, based on the 5 year treasury bond, is 6.22%. The market risk premium assumption is that Ameritrade is a small company stock, with a market value of $273,127 million. The market value is calculated by multiplying the shares outstanding of 14,158 by 18.813, resulting in $273,127.
Therefore, the historical average annual return of small company stocks is 17%.
So the risk premium = Rm – Rf or 17.8% – 6.0% = 11.8%.
h. Cost of Equity = E(Rameritrade) = Rf + ? ameritrade (E ( Rm) – Rf)
iv. = 6.22% + 1.877 (17.8% – 6.0%) = 28.368%
This high cost of capital indicates that most of the revenue is sensitive to the stock market.
The cost of equity according to the Fama-French 3 factor model is calculated using a risk-free rate of 6.22% (based on a 5-year bond) and historical averages from 1926-2008. These averages include Mkt-Rf at 7%, SMB at 3.6%, and HML at 5.2%. Applying the formula, it becomes: 6.22 + (1.99 * 7) + (1.66 * 3.6) + (-0.81 * 5.2) = 21.9%.
