Ameritrade: Case Study

Topics: Capital asset pricing model, Investment, Stock market Pages: 5 (1540 words) Published: June 22, 2013
Executive Summary As a Deep-Discount Brokerage firm, Ameritrade Holding Corporation (AHC) plans to invest in advertising and technology in order to increase their consumer base and thus revenues. The purpose of this report is to assess the riskiness of the proposed investments by considering the project’s cost of capital calculated via the Capital Asset Pricing Model (CAPM). A range of factors will be considered in order to assess each possible variable that may influence the result. Areas of focus include the risk free rate, market index average returns, the market risk premium, identifying suitable comparables and calculating the asset betas. The appropriate risk free rate was calculated using U.S. 10-year securities with an annualized YTM of 6.34%. The proposed investment is assumed to have a ten-year life cycle due to the ever-changing environments of both the discount and Internet industries and the size of investment. Market risk premiums varied depending on the chosen market index. This report opted for the VWI NYSE, AMEX and NASDAQ monthly returns due to their relevance to AHC and its risk characteristics. A historical approach was adopted using returns of the average market proxy from 84’-97’. The average annual return (15.71%) was calculated using the assumed risk free rate and VW market return, the market risk premium was assumed to be 9.37%. Asset betas were calculated using linear regression models plotting monthly market returns against individual assets returns. AHC has a short trading period (IPO in 1997), thus, available data does not satisfy requirements. To calculate beta, comparables calculated average betas for both discount brokerages and Internet industries, resulting in a project beta of 2.045. Using CAPM and the above inputs, the cost of capital was calculated to be 25.5%. This Figure reflects the risks associated with the discount brokerage industry due to low margins and revenues dependent on market performance. It is recommended AHC only implement the proposed investments if the project adds value i.e. is positive-NPV using a cost of capital of 25.5%.

Factors on Proposed Project To evaluate the proposed advertising and technology investments, several factors need to be considered. AHC should only undertake projects positive Net Present Value’s (NPV). To calculate the NPV, an appropriate discount rate, or cost of capital must be established. Therefore, the focus of this report is to identify the risks associated and hence identify a realistic cost of capital. CAPM Model The Capital Asset Pricing Model (CAPM) will be used to calculate the cost of capital. This method has the following inputs, (1) the risk-free rate, (2) the market risk premium and (3) an appropriate asset beta. Solving for CAPM will allow for NPV calculations, aiding the CEO, Joe Ricketts in his final decision regarding the best course of action for AHC. Implementation of Risk Free Rate ( ) and Expected Market Return [E( )]

An appropriate risk-free rate is required to calculate the market risk premium. The project is substantially large ($255m) and is assumed to be a relatively long-term project. Bruner et al (1998) illustrates that the “vast majority of large firms… [use] the yields of long-term (10 to 30year) bonds to determine ”. U.S. government securities (Figure1) are assumed to have AAA

ratings thus are essentially risk-free. Due to the ever-changing discount brokerage and Internet industries, a long horizon would prove ineffective as a technology sourced projects quickly prove obsolete. Therefore the assumption is made that a 10-year project lifecycle is appropriate, from Figure 1, the is 6.34%.

Moreover, to establish a market risk premium an appropriate market index must be identified. As such, the value-weighted (VW) aggregate stock market for the NYSE, AMEX and NASDAQ was chosen. Given the data in Figure 2 the annualized yearly market return (15.71%) can be calculated by annualizing the average monthly return...
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