12.12.2011

Case Study #2

Ameritrade Company

Cost of Capital Evaluation

Executive Summary

The Ameritrade case study analysis brought in this paper comes to estimate the final cost of capital that should be applied to Ameritrade’s technology and marketing investment project. Allegedly, the final purpose of every WACC calculation is in helping to estimate the NPV of a project in order to make a “go\no go” decision, whether it is done by an investor or a creditor. However such a decision requires also the computation of future cash flows. Since we are missing the information regarding Ameritrade’s future cash flows, this paper has one and only goal – to evaluate and discuss the main possible alternatives for estimating Ameritrade’s cost of capital and provide a final recommendation regarding the most appropriate WACC that should be applied.

The paper consists out of two main parts. In the first part, we discuss the major issues that should be considered while evaluating the cost of capital of Ameritrade. For each major issue in our discussion, we considered and discussed alternative ways of action. Among all, we addressed the considerations that should be done while estimating the risk free rate, risk premium rate, tax rate. Beta of equity, beta of debt and others. We put a major emphasis on discussing the considerations that should be done while trying to find the most appropriate comparable company. This is a crucial stage on our way to estimate the beta of equity and the WACC as a whole. After conducting a thorough discussion and presenting the possible alternatives, the second part of the paper presents our final recommendation through the final Ameritrade’s WACC calculations. The assumptions that used us in order to calculate the WACC, and which are based on a previous discussion, are presented in the Appendix part of this paper, as well as all other charts and information that we used to write this paper.

Ameritrade’s cost of capital may be estimated by calculating the WACC, which is the Weighted Average Cost of Capital. To estimate each of WACC’s components, we used different methods, based on different assumptions. First, we had to identify the debt and equity ratios of the firm. To find these ratios we had to consider the existence (and size, if relevant) of Ameritrade zero-interest bearing-debt. One option was to assume a total absence of interest bearing debt. We decided to take on a different approach since we concluded that the firm will have to finance its operations, either by issuing debt, issuing equity or using its available assets. The final capital structure was computed based on the available information and assumptions while taking into considerations the points raised above.

After determining the debt and equity ratios, we started to estimate the WACC components one by one; we identified the effective tax rate, the risk free rate and the risk premium rate. While estimating these values, we had to consider the life time of the project, the appropriate ways to extract the risk free rate and risk premium rate. Among all, we had to decide about the appropriate maturity of US bonds that should be applied and the size of companies that should be used for risk free and risk premium calculations. Another major barrier was calculating the beta of equity and the beta of debt. For beta of equity estimation, as we had not enough reliable information about Ameritrade, we decided to choose Charles Schwab Corporation as our comparable company based on the quality of available information and on its source of revenues – discount brokerage activity, just the same as Ameritrade’s. For beta of debt calculation, we adopted the findings of many empirical studies which show that the beta of debt varies between 0-0.3. We chose the more pessimistic approach, and adopted the value of 0.25. Finally, we presented the financial tools that we used in order to find the final cost of capital, the...