In march 1997, Ameritrade raised $22.5 million in an initial public offering. Management at Ameritrade is considering substantial investments in technology and advertising, but is unsure of the appropriate cost of capital.
Estimating the cost of capital
1. Since we do not have the beta for Ameritrade, we need to find comparable firms for which we could compute the betas. There are several candidates in the case. Discuss which firms are most appropriate.
Thus, the proportion of the revenue a firm earns from transactions and interest (brokerage activities) has something to do with the risk. Thus, to find the firms of comparable risks, we may take a look at the brokerage revenue of the brokerage firms. From exhibit 1, 90 % of the total net revenue of Ameritrade is from brokerage activities.
See Exhibit 4. Which companies would be good candidate as the “comparable firms”?
Considering the brokerage revenue percentage, Charles Schwab, E*trade, Quick & Reilly and Waterhouse Investor appear to be the comparable firms.
2. Find the risk-free rate.
To determine the risk free rate, match the economic life of the project. Considering a significant investment in technology and the goal of the company to be the largest brokerage firm, the project that we are considering is a long term project. Thus, we may use the prevailing yield of 10-year bonds. (See Exhibit 3)
Risk Free rate= 6.34%
3. Find the market-risk premium
We use the difference between the historical large company stocks and long term bonds.
The case offers two tables for the historical averages, one for the average between 1950-1996, and the other for the average between 1929-1996. If there is no significant structural change in the market risk premium, the longer data produces more accurate estimate. However, if there is a significant structural change, more recent data may give better... [continues]
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