Questions and Analysis
What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? 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).
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.
What is the risk-free rate that should be used in calculating the cost of capital using the CAPM? Explain. The risk free rate that should be used when calculating the cost of capital, using the CAPM would be 6. 2%, 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, as with any other technological project, will need updated and will constantly updated/upgraded. All factors considered this would be the best option for CAPM.
What is the estimate of risk-premium on the market that should be used in the CAPM? Explain. The estimate of risk-premium on the market that should be used in CAPM is one of 11. 8%. nowing that Ameritrade is under the cap for a small company and also knowing that the historical averages from 1950-1996 would be more accurate than those from 1929-1996, due to the fact that there was the great depression and WWII, you can estimate the risk-premium with greater accuracy. To find this number simply subtract the rates given in Exhibit 3 (17. 8%-6. 0%) and you get the rate of 11. 8% 5. Ameritrade does not have a beta estimate as the firm has been publicly traded only for a short period at the time of the case. Exhibit 4 provides various choices of comparable firms.
Which firms do you recommend as the appropriate benchmark for evaluating the risk of Ameritrade’s planned advertising and technology investments? Explain. We first need to identify what Ameritrade is, and that is a Deep Discount Brokerage Firm. Some may consider the line of business to be more consistent with an internet firm, however, the core customer base and revenue stream is generated by the exchange fees for administering securities transactions. We feel that this draws a more consistent comparison to the long-term comparison of fellow discount brokerage firms.
Also, there is little data presented in the case to use for calculating risk when reviewing the data for internet firms. If Ameritrade offers a successful business strategy by leveraging its online access, then other competing firms will be sure to follow suit and the industry as a whole adapts to the changing market delivery vehicles. The technology aspect of Ameritrade’s business is essential for execution, but not the business itself. The website does not make money from advertising and is not as differentiated from its competitors with regards to service offerings, but rather convenience.
E*trade would be an ideal firm for comparison, however, there is insufficient historical data to consider E*trade as a viable source of information for benchmarking Ameritrade. Fellow discount brokerage firms, Charles Schwab, Quick & Reilly Group, and Waterhouse Investor Services will be used to evaluate Ameritrade’s investment risk.
Using the data in Exhibits 3, 4, 5 and 6, calculate the asset betas for comparable firms. The asset beta for the comparable firms were calculated to be: Charles Schwab:2. 09 Quick & Reilly:1. 70 Waterhouse:1. 98 Charles Schwab and Quick & Reilly data was used from January 1992 through August 1997.
Waterhouse data was used from January 1992 through September 1996 (since that was all that was available in the case study information. The regression analysis for each of these firms gave us the following data: The following formula was used to find the asset betas: (Unlevering Betas) ? assets = ? debt (D / V) + ? equity (E / V) ? debt was assumed to be 0, while the debt and equity ratios were taken from Exhibit 4. Charles Schwab Quick & Reilly GroupWaterhouse.
What is your estimate of the cost of capital for Ameritrade’s planned investment? 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 and use only those that are discount brokerage firms (Exhibit 4). These firm’s are 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 (historical based on long-term bonds) is 6. 0% and the risk-free rate based on the 5 year treasury bond is 6. 22% g. Market risk premium – Our assumption is that Ameritrade is a small company stock based on their market value of $273,127 million. ii. Market value = Shares outstanding of 14,158 * 18. 813 = $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.
Cost of equity based on Fama-French 3 factor model using 6. 22% risk free rate (5 year bond) and book established average 1926-2008 Mkt-Rf 7%, SMB 3. 6%, HML 5. 2%. =6. 22+(1. 99 *7)+(1. 66*3. 6)+(-. 81*5. 2)=21. 9%