Cost of Capital at Ameritrade free essay sample

Cost of Capital at Ameritrade What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? Mr. Ricketts believes that his role as CEO is to maximize shareholder value by accepting any project whose expected return on investment is greater than the cost of capital. Therefore, the main factors that Ameritrade management should consider are the expected return on investment for the project, and how this compares to the project’s cost of capital.Other factors that should also be considered include: how market swings will affect the expected return on investment, the project’s payback period (the project will require massive initial outlays, so Ameritrade could find itself in financial trouble if results are not seen relatively quickly), the unique risk that would come along with being the only major player in their price range, the risks inherent in being the â€Å"first adopter† of new technology ( unforeseen technical problems, the possibility that price cuts in the near-future could allow competitors to obtain the same technology at a drastically reduced price, etc. We will write a custom essay sample on Cost of Capital at Ameritrade or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page , the relative success of previous advertising campaigns, and the positive effects that an increase in market share could have on future projects. How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real (not financial) investment decision? The CAPM is an important measure when it comes to real investment decisions because it provides a basis of comparison for financial decisions. The return on a project must be greater than what the firm can earn by investing an equivalent amount of money in financial investments.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 in calculating the cost of capital in the CAPM is 5. 24%, which is the current yield on a 3-month T-Bill. We chose this rate because it is the purest risk-free rate available. The longer-term Government bonds also merit consideration because they can more accurately match the maturity of projects. However, no information about the project’s time horizon, expected cash flows, or payback period is given.Therefore, we cannot accurately determine an appropriate maturity for this project. This partially nullifies the benefit of using any rate other than that of the 3-month T-Bill, since we can’t pick a rate that matches the project’s maturity if we do not know the project’s maturity. Although we are not provided with the project’s maturity, we are able to make certain inferences to arrive at an estimate. Since Mr. Rickett’s strategy involves such large initial capital outlays, Ameritrade could find itself in financial trouble if the project doesn’t yield significant cash flows relatively quickly. In addition, the rapidly changing nature of technology means that our â€Å"state of the art† technology might not be state of the art for very long. Based on these two facts, we believe that this will be a short-term project, and that it is therefore appropriate to use a short-term interest rate in order to match the project’s maturity. Since we cannot narrow down the maturity of the project any more than this, we believe that the best interest rate to use is the short-term rate that has the added benefit of being the most risk-free – the 5. 4% yield on a 3-month T-Bill. Another consideration is that the advent of the internet and technology based firms is relatively recent, so we want to reflect this in our cost of capital calculations. What is the estimate of risk-premium on the market that should be used in the CAPM? Explain. When choosing a risk-premium, our goal is to accurately reflect the return on the market. The market return of 14. 0% is the average annual return for large company stocks. Because Ameritrade is a large company, it will be best represented by this return.We are using the data from the years 1950-1996 because we believe this to be a more accurate predictor of equity returns than the averages from 1929-1996. This is because market conditions have become more stabilized as time has passed, so it is useful to exclude data from more volatile time periods. Specifically, we wish to exclude the effects of the Great Depression. Another option is to use data for small companies in order to match the high return and high risk nature of Ameritrade. Although Ameritrade’s investment may make it more risky than the average large company, the beta we have chosen already reflects that higher risk. Therefore, we have chosen to use the market return for large companies because it more accurately depicts an overall picture of the stock market and Ameritrade’s status as a large firm. After subtracting the chosen risk-free rate of 5. 24% from the average large company market return of 14. 0%, we estimated the market risk-premium to be 8. 76%. 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. Although technically Ameritrade is a discount brokerage, because their prices are so much lower than their competitors, their revenue depends on the volume of transfers more than anything else. Their system is very different from other discount brokerages who can earn a more significant margin on their trades.The idea of making money based on volume is much more comparable to internet sites like Yahoo and Netscape, who make their money through advertisers who pay them according to how much traffic their websites receive. Also, discount brokerages rarely make such large investments in technology, while internet firms must always keep technology current to maintain a competitive edge. Another similarity with the internet firms is Ameritrade’s lack of debt. For these reasons, we believe that the internet firms provide the best benchmark for determining Ameritrade’s beta.Because the risk is quite variable among the internet firms, we have decided to take an equally weighted average of all the equally weighted betas to determine an appropriate beta for Ameritrade. We decided to use the equally weighted numbers because we do not have the market caps for any of the tech companies, so we are not able to determine a value weighted beta. For consistency in our calculations, we also decided to use the equally weighted stock market indices in our regression analysis. Using regressions against the EW Indices provided to us in exhibit 6 we found the betas of the internet firms to be:Meckler- 1. 149 Netscape- 1. 402 Yahoo- 3. 162 We considered not including Yahoo in our beta calculations because it has such a high beta and only 16 months of returns, which may make it less reliable than firms for whom more information is available. We decided to include it because its high beta reflects the high-risk nature of this industry and our possible investment in this project. What is your estimate of the cost of capital for the Ameritrade’s planned investment? Provide all your assumptions.