Case Study of Cost of Capital at Ameritrade
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...
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