Ameritrade should use a 6.10% risk free rate when calculating its cost of capital. This is the average of the 20 year bond annualized yield to maturity (on August 31, 1997) and the long term historical average annual return (from 1929 1996). The long term bond return was used because it provides an accurate average annual return since it reflects many years. The 20 year bond as of August 31, 1997 was used because it is the current yield to maturity. They were averaged in order to get a rate that would reflect current rates, but also be more reliable since it involves data from many years.
Ameritrade should use a 1.3% market risk premium. In order to derive that, the average risk free rate of past years was subtracted from the average weighted return of the market from past years. This was done to accommodate for fluctuations in the market.
Charles Schwab, Raymond James, Quick &Reilly, A G Edwards, and Mecklermedia, were used as benchmarks for evaluating the risks of Ameritrade's planned advertising and technology investments. Charles Schwab was chosen because they are Ameritrade's closest competitor. The other companies were chosen because they had similar debt to equity ratios as Ameritrade. These firms focused more on equity than debt.
The asset betas for each of the benchmark firms were calculated by taking the...