Questions and Analysis
1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? a. 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. b. 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. c. 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. d. 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). 2. 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. 3. 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 6.22%, 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...
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