Ameritrade's Cost of Capital Harvard Case Study
1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? One factor that is significant and pertinent to this case is determining the cost of capital that should be employed for Ameritrade. An appropriate discount rate is required to derive the net present value of the advertising program and technology upgrades. With that said, estimating future cash flows should be based on investing activities, which include the initial cash outlays, salvage values and net working capital, and operating activities, which include forecasted changes in revenues and costs after taxes and depreciation. Taxes will either reduce operating profit or result in a tax credit if the firm experiences an operating loss. The depreciation method used will affect the amount of taxable income. Determining the project life and inflation are also critical parts of the capital budgeting decision.
2. How can the Capital Asset Pricing Model be used to estimate the cost of capital for a real (not financial) investment decision? The intuition behind CAPM is that the expected return on a stock is comprised of the risk free rate and the market risk premium. The market risk premium consists of both business risk or the firm’s sensitivity to business cycles and financial risk or the amount of long-term debt the firm carries. The more debt a firm holds the more susceptible to systematic risk the firm will be. For example, higher fixed interest payments will be especially detrimental to the firm during market recessions. The beta on a levered firm reflects both business and financial risk. Thus, CAPM concludes that a stock’s risk premium is beta times the market risk premium. Adding the risk free rate will give us the cost of equity. The firm’s weighted average cost of capital is determined by taking the percentage of equity at market value...
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