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 estimate of the risk premium. We are not sure which one is better. So let us use both case.

Risk premium (1950-1996)=14.0% – 6.0%=8%

Risk Premium (1929-1996)=12.7% – 5.5%=7.2%

4. Compute the equity betas for comparable firms. Then based on the results, compute the asset beta for each firm.

Exhibit 5 shows the stock prices for the comparable firms. The return is computed as

Return = (Pt+1 – Pt + Divt+1)/Pt

As can be seen, there have been some incidences of stock split. 3 for 2 means that 2 shares are split into 3 shares. Now, using the VM NYSE (Value weighted NYSE index) as the proxy for the market return, compute equity betas for each company. Use the past 5 years of data to compute the beta. After computing equity beta, using the Debt-value ratio in Exhibit 4, unlever the equity beta, (i.e., compute the asset beta from equity beta).

5. Taking the average of the asset betas for the comparable firms, and use this as the estimate for the asset beta for Ameritrade.

Estimate the asset beta for the Ameritrade

The compute the cost of capital for Ameritrade.

The estimated cost of capital should be around 20%. Relatively high cost of capital reflect the fact that most of the revenue is highly sensitive to the stock market.

6. Use the estimated asset beta, compute the cost of capital.

1. Primary Sources of Revenue

a) Transaction – commission, clearing fees and payment for order flow b) Interest – charging customers on debt balances and investment of customers’ cash segregated in compliance with federal regulations in short-term securities.

2. How risky are these cash flows? How related to stock market? Virtually all revenues are directly linked to the stock market and in a downturn, investors decrease their trading activity and borrowing so revenues decline substantially.

3. How can CAPM be used to estimate the cost of capital for real investment decision? CAPM can be applied to any security as well as a real investment. We...