In mid-1997 Joe Ricketts the Chairman and CEO of Ameritrade, decided that Ameritrade’s new mission would be to become “the largest brokerage firm worldwide based on the number of trades.” In order to accomplish this mission Ameritrade would need to invest significantly in technology and advertising. This strategy would require large expenditures relative to Ameritrade’s existing capital. In order to gauge the financial impact of these large expenditures, there needed to be some accounting for the riskiness of the project. The average return on equity for Ameritrade from 1975 to 1996 was 40% and recent returns were much higher, with each of the most recent five years having larger returns than the 40% average. Ricketts understood that the plan would only create value if the investment returned more than it cost, but what was the cost of capital. The key questions to answer this problem are: 1. What is the estimate of the risk-free rate that should be employed in calculating the cost of capital for Ameritrade? Why? and 2. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade? Why?
The estimate of the risk free rate that should be employed in calculating the cost of capital is 6.61%. This is the yield on the 30-year government bonds according to exhibit 3 in the appendix. We used this rate because we feel it is a safer rate to use than other shorter term rates and it will give us a more accurate depiction of the true cost of capital. The estimate of the market risk premium that should be employed in calculating the cost of capital is 11.19%. We calculated this rate by using the historical average of small-caps at 17.8% and subtracting out the risk free rate of 6.61%.
In 1997, the Chairman and CEO of Ameritrade Holding Corporation, Joe Ricketts, wanted to improve Ameritrade’s competitive position in the deep-discount brokerage market. In order...