Financial Investment Decisions
1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? Ameritrade management should consider the cost of capital because this factor takes the cost of debt and the cost of equity into account. A firm would receive this rate of return if investing elsewhere with similar risk. This is the minimum return that investors expect, which allows management to set a benchmark for the new program. The NPV should be assessed, and the project should only be accepted if the result is positive.
Management should consider expected return on investment, only accepting a positive ROI. The fact that Ameritrade is such an early adopter may cost them more money. The cost for the same upgrades may go down in price to Ameritrade’s competitors, Charles Schwab and E*Trade, and they could ultimately obtain the same state of the art technology cheaper while piggy-backing off of advertising. The company needs to consider future cash flows because a lot of the cash will be tied up in their investment, and is used as a financial strength indicator.
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A high debt to equity ratio will show that the company financed its growth with debt, which can ultimately lead to significant loss. 2. How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real (not financial) investment decision? Real investment decisions pertain to land, buildings, gold and silver, whereas financial investment decisions pertain to shares, bonds, and other securities. When using CAPM to estimate the cost of capital for real investment decision, the market risk premium is weighted by the index of the systematic risk of the real investment as defined by capital market theory.
The CAPM can be used to estimate this cost by looking at other investments with similar risks and comparing the expected rates of return. Beta has to be determined for a company’s average project by measuring the systematic risk of the firm and adjusting for financial leverage. CAPM provides a way to compare financial decisions, and when the return on a project is greater than returns from financial investments they should be considered.