Cost of Capital at Ameritrade

Topics: Rate of return, Finance, Security Pages: 5 (1067 words) Published: September 28, 2011
Case Solution
Cost of Capital at Ameritrade
| | • Executive summary:
Formed in 1971 and listed in March 1997, Ameritrade has been one of the most successful players in the deep- discount brokerage sector. Ameritrade’s two major sources of revenue, Transaction income (brokerage commissions, clearing fees, and payment for order flow) and Net interest revenues that were generated from net balance of customers’ brokerage accounts and the investment of customer’s cash segregated in compliance with federal regulations in short term marketable securities contributes over 90% of its revenue. The company management is now proposing huge capital spending projects on advertising (estimate spending is $155M) and technology enhancements (estimated spending is $100M). Now the company is assessing the reasonableness of the investment, mainly considering the estimate internal return rate comparing with the weighted average cost of capital. The key factor will be the WACC, the higher rate of WACC, the higher risk for the investment. Based on our assessment which detail stated as below, we learnt that the cost of capital for Ameritrade is very high (around 25%) based on the assumptions we used, hereby we rate the investment risk at high level. Key assumptions used:

- Long term investment for program life between 10 to 20 years; - Using market comparable companies’ data to calculate Ameritrade’s beta - Small listed company
• Calculation of WACC
1. Source for the cash of the spending for the proposed projects. a. Increasing debt for the project financing. This will significant reduce the cost of capital but will increase risk of cash flows remaining for stockholders because the safest cash flows went to the debt holders. Also, as a company with high market risk (variable competitors), and low net current assets (risk for the debt return), it is not easy to finance the cash in this way. b. Using equity to finance the cash is more acceptable way. If we use the assumption that the company will use equity method for the financing, we will set up the assumption that the WACC=cost of capital (equity). 2. [pic]cost of capital

a. Risk free rate
Since it is a long term investment (significant capital spending with expected cash return in future years) and normally the technical upgrades won’t last very long, we expected the annual return (normally less than 20 years), also the 10 years bond/20 years bond do not have significant variance for the rates, we used the average long term bonds to set up the risk free rate, which is 6.5%. |  |Annualized Yield to Maturity |  | |3-Month T-Bills |5.24% | | |1-Year Bonds |5.59% | | |5-Year Bonds |6.22% | | |10-Year Bonds |6.34% | | |20-Year Bonds |6.69% | | |30-Year Bonds |6.61% | |

b. Market risk premium
The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate. Since the company is a technical based company in Nasdaq (which has low entrance limited to small companies), also comparing with the net asset, revenue and profit level of the company, we classify the company as a small company with historical annual return rate of 17.8%. |Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1950-1996) | |  |Average Annual Return...
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