Case: Cost of Capital at Ameritrade
Ameritrade is formed in 1971, and is a pioneer in the deep-discount brokerage sector. [A deep-discount broker is a broker that offers lower commissions than a discount broker, but also provides fewer services to clients. Such a broker usually will not provide anything beyond execution of stock and option trades, and will charge a flat fee regardless of the size of the trade]
In march 1997, Ameritrade raised $22.5 million in an initial public offering. Management at Ameritrade is considering substantial investments in technology and advertising, but is unsure of the appropriate cost of capital.
Since the firm has been publicly traded for only a short time period, it does not have data to estimate its beta. Using the data provided in the case, we were asked to estimate the appropriate discount rate for the firm.
Factors to Consider (when evaluating the
proposed advertising and technology expenditures) Future Revenues Future Cash Flows Debt to Equity Ratio Return on Equity / Cost of Equity
Use CAPM for Investment Decisions
COST OF CAPITAL = OPPORTUNITY COST Compare CAPM results to the expected rates of return that Ameritrade can earn in other investments with similar risks
Risk Free Estimate
10 year US government bonds = 6.34% return Historical Risk Free Rate = 6%
Estimating the cost of capital
The steps below estimate the cost of capital at Ameritrade.
Since we do not have the beta for Ameritrade, we need to find comparable firms for which we could compute the betas. There are several candidates in the case. Find the risk-free rate. Find the market-risk premium 7
Estimating the cost of capital (Contd)
Compute the equity betas for comparable firms. Then based on the results, compute the asset beta for each firm. Taking the average of the asset betas for the comparable firms, and use this as the estimate...
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