Ameritrade: Cost of Capital
What factors should Ameritrade Management consider when evaluating the proposed advertising program and technology upgrades? Why? When considering the proposed advertising program and technology upgrades, we have to ensure that the project will likely add value to the company, so we need to consider the return on investment versus the cost of capital. If the return on investment, measured by the net present value and internal rate of return, exceeds the cost of capital, the investment should be taken. In addition, we need to evaluate the project’s systematic risk (beta), which includes risks that are not unique to a particular project and not easily manageable by a project team at a given point in time.
How can the C.A.P.M be used to estimate the cost of capital for a real (not financial) investment decision? C.A.P.M describes the relationship between risk and expected return of the investment. In order to use the CAPM to estimate the cost of capital for this investment decision, we need to identify comparable companies, extract their unlevered beta (since we don’t have the information for Ameritrade), determine the appropriate manner to average them, and apply the resulting beta to the investment’s CAPM. We use an unlevered beta of comparable companies because every company has a unique capital structure and leverage has no affect on the risk or return of a firm's assets.
What is the estimate of the risk-free rate that should be employed in calculating the cost of capital for Ameritrade? Because Ameritrade is going to make a substantial investment in technology and the objective of the company is to become the largest discount brokerage firm, we are considering this to be a long term project. To match the economic life of the project, we will use the prevailing yield of long term bonds. Yield to maturity of 30-Year Bonds is 6.61%
So the estimate of risk-free rate that should be employed in calculating the cost of capital...
Please join StudyMode to read the full document