Cost of Capital at Ameritrade
What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why?
Mr. Ricketts believes that his role as CEO is to maximize shareholder value by accepting any project whose expected return on investment is greater than the cost of capital. Therefore, the main factors that Ameritrade management should consider are the expected return on investment for the project, and how this compares to the project’s cost of capital. Other factors that should also be considered include: how market swings will affect the expected return on investment, the project’s payback period (the project will require massive initial outlays, so Ameritrade could find itself in financial trouble if results are not seen relatively quickly), the unique risk that would come along with being the only major player in their price range, the risks inherent in being the “first adopter” of new technology (unforeseen technical problems, the possibility that price cuts in the near-future could allow competitors to obtain the same technology at a drastically reduced price, etc.), the relative success of previous advertising campaigns, and the positive effects that an increase in market share could have on future projects.
How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real (not financial) investment decision?
The CAPM is an important measure when it comes to real investment decisions because it provides a basis of comparison for financial decisions. The return on a project must be greater than what the firm can earn by investing an equivalent amount of money in financial investments.
What is the risk-free rate that should be used in calculating the cost of capital using the CAPM? Explain.
The risk-free rate that should be used in calculating the cost of capital in the CAPM is 5.24%, which is the current yield on a 3-month T-Bill. We chose this rate because it is the purest risk-free rate available. The longer-term Government bonds also merit consideration because they can more accurately match the maturity of projects. However, no information about the project’s time horizon, expected cash flows, or payback period is given. Therefore, we cannot accurately determine an appropriate maturity for this project. This partially nullifies the benefit of using any rate other than that of the 3-month T-Bill, since we can’t pick a rate that matches the project’s maturity if we do not know the project’s maturity. Although we are not provided with the project’s maturity, we are able to make certain inferences to arrive at an estimate. Since Mr. Rickett’s strategy involves such large initial capital outlays, Ameritrade could find itself in financial trouble if the project doesn’t yield significant cash flows relatively quickly. In addition, the rapidly changing nature of technology means that our “state of the art” technology might not be state of the art for very long. Based on these two facts, we believe that this will be a short-term project, and that it is therefore appropriate to use a short-term interest rate in order to match the project’s maturity. Since we cannot narrow down the maturity of the project any more than this, we believe that the best interest rate to use is the short-term rate that has the added benefit of being the most risk-free – the 5.24% yield on a 3-month T-Bill. Another consideration is that the advent of the internet and technology based firms is relatively recent, so we want to reflect this in our cost of capital calculations.
What is the estimate of risk-premium on the market that should be used in the CAPM? Explain.
When choosing a risk-premium, our goal is to accurately reflect the return on the market. The market return of 14.0% is the average annual return for large company stocks. Because Ameritrade is a large company, it will be best represented by this return. We are...
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