Executive Summary: In the mid-1997, Joe Ricketts, Chairman and CEO of Ameritrade, made the strategic decision to transform Ameritrade into the leading brokerage firm in terms of trade volume. This ambitious plan necessitated substantial investments in technology and advertising, surpassing their existing financial resources. Thus, it was crucial to assess the level of risk tied to these expenditures to gauge their financial implications.
From 1975 to 1996, Ameritrade had an average return on equity of 40%, and the recent returns have been even higher, surpassing the average for each of the last five years. Recognizing that the investment plan’s value depended on exceeding costs, Ricketts understood the crucial nature of determining the cost of capital. To address this question, two key inquiries must be answered:
- What is the estimate of the risk-free rate that should be utilized in calculating Ameritrade’s cost of capital? Why?
- What is the estimate of the market risk premium that should be utilized in calculating Ameritrade’s cost of capital?
According to exhibit 3 in the appendix, the cost of capital is determined using a risk-free rate of 6.61%, which is based on the yield of 30-year government bonds and chosen for its accuracy compared to shorter-term rates. Additionally, the market risk premium used for calculating the cost of capital is estimated at 11.19%. This estimation was derived by subtracting the risk-free rate of 6.1% from the historical average of small-caps at 17.8%.
In 1997, Joe Ricketts, Chairman and CEO of Ameritrade Holding Corporation, set out to improve Ameritrade’s competitive position in the deep-discount brokerage market by investing in technology and advertising. His goal was to target self-directed investors and make Ameritrade the world’s largest brokerage firm based on trading volume. To evaluate this strategy’s potential cash flow and estimate project risk, significant capital expenditure was necessary.
Established in 1971, Ameritrade has been a pioneering force in deep-discount brokerage services. They not only played a crucial role in developing this market but also introduced innovative services that revolutionized how individuals manage their portfolios.
The average return on equity from 1975 to 1996 was 40%, and recent returns in the past five years have exceeded this average. In March 1997, Ameritrade raised $22.5 million through an initial public offering (IPO), which allowed the company to adopt advanced technologies, improve their advertising campaigns for brand enhancement, and increase their market share. Ameritrade’s main sources of revenue were transactions and net interest, indicating a strong correlation between its net revenue and stock market activities.
Ameritrade was more affected by stock market declines compared to full-service brokers. This was because full-service brokers minimized the impact of market declines by diversifying their income through asset management fees and investment banking activities. Ricketts implemented a strategy that included price reduction, technology improvements, and increased advertising. The commission on a trade was initially reduced from $29.95 to $8.00. Additionally, $100 million was allocated for technology enhancements to improve trade execution speed.
Ameritrade increased its advertising budget to $155 million for the combined fiscal years of 1998 and 1999. The success of this plan depended on the investment generating a higher return than its cost. Ricketts, who aimed to maximize shareholder value, was willing to invest in this project as long as the expected returns exceeded the cost of capital. However, determining the cost of capital was essential. 1. In general, the projected present value of future cash flows should surpass the costs by utilizing the company’s cost of capital as the discounting factor.
Both programs involve risk, leading to an increase in expected returns for the company. It is important for the chosen programs to satisfy investors’ return expectations reasonably. The company aims to become the top provider of trustworthy online brokerage services and plans to achieve this by boosting advertising efforts. To accomplish this, the company needs to consider various advertising mediums such as television, newspaper, magazine, online, and mailing. Conducting focused groups can help determine the most effective means of expanding its customer base. Additionally, analyzing the cost per advertisement for each medium is crucial. Ideally, the company should invest in a well-balanced combination that maximizes revenue relative to advertising expenses.
The positive NPV can be achieved by increasing revenue and discounting at the cost of capital. The company should take into account the adaptability and compatibility of the technology. By opting for a flexible and compatible technology, the company can easily adjust to future technological needs without major investments in different technologies. This will also help the company to reach its goal of 100% reliability. Additionally, all relevant costs related to the technological upgrade should be considered, including employee training, future costs, IT support, and the depreciation effect on Free Cash Flows.
To ensure complete reliability, it is vital for the company to thoroughly evaluate how technological upgrades will affect the speed and dependability of trade execution. It is also important to comprehend customer preferences and the potential consequences of proposed upgrades. Furthermore, any modifications made should prioritize user-friendliness.
The risk-free rate estimate for calculating the cost of capital stands at 6.61%. This calculation is derived from the yield of 30-year government bonds, as evidenced in exhibit 3 of the appendix.
We decided to utilize this rate because it is deemed more secure in comparison to other rates with shorter terms, thus granting us a more precise depiction of the actual capital cost. The estimation for the market risk premium, which is utilized in determining the cost of capital, stands at 11.19%. We obtained this rate by subtracting the risk-free rate of 6.61% from the historical average of small-caps at 17.8%. As Ameritrade operates as a discount brokerage, its revenue primarily relies on transactions, rendering it more susceptible to stock market fluctuations when contrasted with a full-service brokerage.
From 1995-1997, Ameritrade generated an average of 68% of its revenue from transaction income. To identify firms with a similar risk level, we examined the brokerage revenues of discount brokerage firms. Among them, E*Trade and Quick & Reilly stood out due to their high percentage of revenue derived from brokerage (95% and 81% respectively). Furthermore, both E*Trade and Quick & Reilly are unlevered, which sets them apart from other discount brokerage firms like Charles Schwab and Waterhouse, making them more comparable to Ameritrade.
