Ameritrade – Cost of Capital
Group Case 1: Ameritrade – Cost of Capital
Executive Summary:
As a deep-discount brokerage, Ameritrade planned to improve its competitive position by price cutting, technology enhancements, and increased advertising in mid-1997. Before initiating the plan, Ameritrade needed know whether the investment returned more than it cost. We were hired to estimate the cost of capital correctly. The key question is to find suitable comparable firms to estimate Ameritrade’s asset beta, since it was a recently-listed firm. We thought discount brokerage companies were best due to same revenue resources. Proper risk-free rate and market risk premium should also be chosen carefully, and we used 30-year bonds YTM and the annual return difference between large company stocks and long term bonds respectively. In the end, we came to the conclusion that Ameritrade’s cost of capital is 20.81%, higher than pessimistic and lower than optimistic expected return.
Body of the write-up: 1. Factors Ameritrade management should consider when evaluating the proposed advertising program and technology upgrades.
The company needed to consider return and risk. That is whether the expected returns on investment were greater than the cost of capital. If the return on investment is higher than the cost of capital, the advertising program and technology upgrade can bring profits for the company. The investment becomes worthy. Otherwise, the investment will definitely cause loss for the company. What’s worse is that the investment can cause bankruptcy of the company. 2. Choose the best estimate of the risk-free rate in calculating the cost of capital.
The risk-free rate should equal to long term treasury bond rate, which is the 30 year bonds rate 6.61% (Exhibit 3 Capital Market Return Data). It is the minimum return an investor expects for any investment. First, long-term bond experiences a long time. Due to inflation and uncertainty, the bond return should be the most suitable return
Executive Summary:
As a deep-discount brokerage, Ameritrade planned to improve its competitive position by price cutting, technology enhancements, and increased advertising in mid-1997. Before initiating the plan, Ameritrade needed know whether the investment returned more than it cost. We were hired to estimate the cost of capital correctly. The key question is to find suitable comparable firms to estimate Ameritrade’s asset beta, since it was a recently-listed firm. We thought discount brokerage companies were best due to same revenue resources. Proper risk-free rate and market risk premium should also be chosen carefully, and we used 30-year bonds YTM and the annual return difference between large company stocks and long term bonds respectively. In the end, we came to the conclusion that Ameritrade’s cost of capital is 20.81%, higher than pessimistic and lower than optimistic expected return.
Body of the write-up: 1. Factors Ameritrade management should consider when evaluating the proposed advertising program and technology upgrades.
The company needed to consider return and risk. That is whether the expected returns on investment were greater than the cost of capital. If the return on investment is higher than the cost of capital, the advertising program and technology upgrade can bring profits for the company. The investment becomes worthy. Otherwise, the investment will definitely cause loss for the company. What’s worse is that the investment can cause bankruptcy of the company. 2. Choose the best estimate of the risk-free rate in calculating the cost of capital.
The risk-free rate should equal to long term treasury bond rate, which is the 30 year bonds rate 6.61% (Exhibit 3 Capital Market Return Data). It is the minimum return an investor expects for any investment. First, long-term bond experiences a long time. Due to inflation and uncertainty, the bond return should be the most suitable return