1-a How can the CAPM be used to estimate the cost of capital for a real business investment decision? CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio. So, the cost of capital of any investment opportunity equals the expected return of available investments with the same beta. This estimate is provided by the Security Market Line equation of the CAPM with states that, given the beta, of the investment opportunity, its cost of capital is Ri=rf+Bi*(E[Rmkt]-rf)
In other words, investors will require a risk premium comparable to what they would earn taking the same market risk through an investment in the market portfolio. 1-b What type of cash flows and discount rate you are evaluating in this project? Is there any financial effect (i.e. leverage) involved? Why, or why not?
We use free cash flows and the asset cost of capital as discount rate in evaluating this project. There is financial effect involved, since the Ameritrade have both debts and equity. 2. What estimate of the risk-free rate should be employed in calculating the cost of capital for Ameritrade? Explain clearly the reason for your choice. We use current yield of 10-year U.S. government bond as risk-free rate, which is 6.34%. Because we are estimating a project which will occur in the future, so the current yield is forward-looking, The U.S. government bond is default free, so it is reasonable to set as risk-free rate. The majority of large firms and financial analysts will use the yields of long-term (10- 30 years)bonds to determine the risk free interest rate. Here we think the cash flow generate by the technology investment will last about 10 years, so we choose 10 year U.S. government bond as risk free rate. 3. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade? Should you use long or short-term series? Portfolios of large or small stocks? Estimate of the market risk premium= E[Rmkt]-rf =14%-6%=8%
We will use short-term series (1950-1996) because very old data may have little relevance for investor’s expectation of the market risk premium today. We also use portfolios of large stocks because large stock have large weight in the market, it can reflect the market situation better than small stock. So the result is the Average Annual Return of large stock from1950 to 1996 minus the Average Annual Return of long term bonds from1950 to 1996. 4. Ameritrade does not have a beta estimate as the firm has been publicly traded for only a short time period. Exhibit 4 provides various choices of comparable firms. What comparable firms do you recommend as the appropriate benchmarks for evaluating the risk of Ameritrade’s planned advertising and technology investments? Why? We recommend choosing Charles Schwab Corp, Quick & Reilly Group and Waterhouse Investor Srvcs and E*Trade as the appropriate benchmarks for evaluating the risk of Ameritrade’s planned advertising and technology investment, because the business of them are similar to that of Ameritrade Holding Corp: All of these companies are focus on discount brokerage business, which represent more than 80% of their revenues.
5. Using the data provided in the case (stock price, returns data and capital structure information), calculate the asset betas for the companies that are appropriate comparables for Ameritrade. Which comparable firms’ Debt/Value ratios do you use, and why? Firstly we need to calculate the Beta of Equity for these four stocks. We noticed that the data of E*Trade’s stock...