Ameritrade
Ameritrade Cost of Capital
FIN 700
11/14/06
Cohort B-Team 3
Introduction Ameritrade CEO Joe Ricketts contracted our firm, B3 Investment Consultants, to provide quantitative analysis of a prospective project – entering the deep discount brokerage market. Based on the directives given by Mr. Ricketts, the primary focus of our analysis has been to derive an accurate estimate of the weighted average cost of capital (WACC) for this project. Mr. Ricketts requested that we also generate a model of the project’s potential cash flows and the impact of those cash flows on Ameritrade’s stock price over the next five years. Our findings are summarized in the following report.
I. WACC Calculation To determine the WACC for this project we need to know the following; the current risk free rate, the market risk premium, and an asset beta appropriate to this project. We selected the current 30-year U.S. government bond yield of 6.61% as the appropriate comparative risk free rate. U.S. government bonds are considered risk-free investments because the likelihood that the government will be unable to pay is so small as to approach zero. The 30-year bond is used because of the going concern assumption and the need to match the perpetuity provided by the project with a bond of a comparable time horizon. To derive the market risk premium, we looked at the historical performance of the S&P 500, which is often used as a proxy for the market as a whole. The average annual return for the S&P 500 for the period from 1929 to 1996 is 12.7%. We would then subtract the average annual risk-free rate from that same period to calculate the market risk premium. The average annual return for long-term U.S. government bonds over that same period is 5.5%. Subtracting the risk free rate of 5.5% from the market return of 12.7% gives us a market risk premium of 7.2%. The final component of the WACC calculation is
FIN 700
11/14/06
Cohort B-Team 3
Introduction Ameritrade CEO Joe Ricketts contracted our firm, B3 Investment Consultants, to provide quantitative analysis of a prospective project – entering the deep discount brokerage market. Based on the directives given by Mr. Ricketts, the primary focus of our analysis has been to derive an accurate estimate of the weighted average cost of capital (WACC) for this project. Mr. Ricketts requested that we also generate a model of the project’s potential cash flows and the impact of those cash flows on Ameritrade’s stock price over the next five years. Our findings are summarized in the following report.
I. WACC Calculation To determine the WACC for this project we need to know the following; the current risk free rate, the market risk premium, and an asset beta appropriate to this project. We selected the current 30-year U.S. government bond yield of 6.61% as the appropriate comparative risk free rate. U.S. government bonds are considered risk-free investments because the likelihood that the government will be unable to pay is so small as to approach zero. The 30-year bond is used because of the going concern assumption and the need to match the perpetuity provided by the project with a bond of a comparable time horizon. To derive the market risk premium, we looked at the historical performance of the S&P 500, which is often used as a proxy for the market as a whole. The average annual return for the S&P 500 for the period from 1929 to 1996 is 12.7%. We would then subtract the average annual risk-free rate from that same period to calculate the market risk premium. The average annual return for long-term U.S. government bonds over that same period is 5.5%. Subtracting the risk free rate of 5.5% from the market return of 12.7% gives us a market risk premium of 7.2%. The final component of the WACC calculation is