Case Questions Cost of Capital at Ameritrade Corp PDF

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Case Study Guidelines Students are required to read closely the assessment criteria for both case study presentation and written report as listed on the course outline (page 5 to 6). Case Study Questions Presenting groups need to address the following questions in their presentations. Cost of Capital at Ameritrad Ameritrade e

1) What fact factors ors should Ameritrade mana management gement consider when eval evaluating uating the proposed adv advertising ertising progr program am and technology upgr upgrades? ades? Why? Need to consider: - The cost of capital to evaluate new projects, as the cost of capital allows us to know the minimum return investors expect, or the opportunity cost of investing in the project instead of something else. The expected return on capital has to exceed the cost of capital for the project to be profitable. If cost of capital is high, this indicates that higher returns are required before Ameritrade should undertake the higher risks associated with the project. - Project’s NPV. A larger expected future cash flow means a larger NPV for the project. Additionally, when calculating the NPV, the management needs to be very careful with the degree of discount rate it applies. An inappropriate discount rate will result in under- or overvaluing the project. Tax rates, the cost of each debt and equity and preferred stock are important factors in calculating WACC. - Other factors that should also be considered include: project life, cash flows to and from Ameritrade ie initial cash outlays, salvage values and net working capital, how market swings will affect the expected return on investment, the project’s payback period (the project will require massive initial outlays, so Ameritrade could find itself in financial trouble if results are not seen relatively quickly), the unique risk that would come along with being the only major player in their price range, the risks inherent in being the “first adopter” of new technology (unforeseen technical problems, the possibility that price cuts in the near- future could allow competitors to obtain the same technology at a drastically reduced price, etc.), the relative success of previous advertising campaigns, and the positive effects that an increase in market share could have on future projects. The Ameritrade analysts should consider, that their company’s internal discount rate was often used as 15%, but some managers felt appropriate the rate of 8-9%. At this time, the external discount rate, used by Credit Swiss First Boston was 12%. - 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 u used sed to estimate the cost of capital for a re real al (not financial) inve investment stment decision? . 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 times the cost of equity plus the percentage of debt at market value times the

cost of debt minus taxes. Since CAPM gave us the cost of equity we only need the YTM on the firm’s outstanding debt to derive the WACC. The CAPM is an important measure when it comes to real investment decisions because it provides a basis of comparison for financial decisions. The return on a project must be greater than what the firm can earn by investing an equivalent amount of money in financial investments. The CAPM model can be used to estimate the cost of capital for a real(not financial) investment decision. Its purpose is to measure the riskiness of an investment. The cost of capital of the investment must be greater than its return on asset. With the appropriate asset beta, risk free rate and market premium risk, the CAPM model allows us to find the required return on asset: Ra= Rf + βa (Rm-Rf) . Since it's a real investment decision, we have to consider both systematic and unsystematic risks. 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 .Based on the case, we realize that Ameritrade has a very high systematic risk because a substantial decline in the stock market could highly decrease its revenue. However, the CAPM model suggests that unsystematic risk should have almost no effect on the required rates of return because it only has very minimal impact on the overall variability of diversified portfolio. In addition, the CAPM model also takes into account the asset beta, or the systematic risk, which is not diversifiable. Together, the systematic and unsystematic risks decide the amount of compensation Ameritrade should get in return for the risk it takes. ~~~~ The Weighted Average Cost of Capital (WACC) of a firm requires weighted values of the cost of equity, debt and preferred stock. Since Ameritrade does not have any long-term debt items in its 1996-97 balance sheets, we assume that they will continue with this equity -only capital structure. Although short-term debt that rolls over each year can be considered part of the capital structure, we negate this possibility due to no notes payable rolling over from 1996 -97. The cost of equity portion of WACC can be derived from the Capital Asset Pricing Model (CAPM) , the Discounted Cash Flow method or Bond-Yield-Plus-Risk Premium. Here, we will utilise CAPM due to insufficient data for the DCF method, and the largely discretionary nature of Bond-Yield-Plus-Risk Premium. The cost of equity or common stock incorporates a risk free return as well as an additional return for the risk undertaken in investing in a risky asset, calculated by the market risk premium factored by the asset’s beta (the risk of a company relative to that of the market). The sum of these two components provides an adequate computation of the expected return of y a compan ysstock, also known as the cost of equity. The CAPM as a reflection of systematic risk and its influence on the expected return of a stock is observed through the market risk premium, a direct relationship in which the higher the systematic risk leads to a higher market risk premium demanded by investors for the additional risk taken on. Subsequently a higher market risk premium increases the cost of equity, leading to a higher WACC. Similarly the inverse applies. 3) What is the estimate of the risk risk-free -free rate a and nd market risk prem premium ium that should be employ employed ed in calculating the cost of capital for A Ameritrade? meritrade? Risk free rate - Assuming a project life of 10 years, we employed the forward-looking, prevailing 10year Treasury rate as of August 29th, 1997, which was 6.34%. Since this project concerns future investments, we should use current market rates rather than historical rates. Using the prevailing yields on US Government Bonds, we can approximate the risk free rate. Assuming the project is a long -term project, we accordingly use returns on long -term bonds. As the project heavily invests in technology, which is a fast developing area, we use the YTM on 10 -year bonds rather than on the longer 20 or 30-year bonds. This is in response to the possibility of new technology requirements arising. The risk-free rate is 6.34%. OR According to Exhibit 3, we choose to use the prevailing yield of 20-year bonds, 6.69%,to be our risk free rrate ate ate. We believe the yield of 20-year bonds is a better fit for Ameritrade since they¶re

considering a long-term and significant capital investment, and the company is operating in an industry that is always in flux. ~~~~~ The risk-free rate that should be used in calculating the cost of capital in the CAPM is 5.24%, which is the current yield on a 3-month T-Bill. We chose this rate because it is the purest risk-free rate available. The longer-term Government bonds also merit consideration because they can more accurately match the maturity of projects. However, no information about the project’s time horizon, expected cash flows, or payback period is given. Therefore, we cannot accurately determine an appropriate maturity for this project. This partially nullifies the benefit of using any rate other thanthat of the 3-month T-Bill, since we can’t pick a rate that matches the project’s maturity if we do not know the project’s maturity. Although we are not provided with the project’s maturity, we are able to make certain inferences to arrive at an estimate. Since Mr. Rickett’s strategy involves such large initial capital outlays, Ameritrade could find itself in financial trouble if the project doesn’t yield significant cash flows relatively quickly. In addition, the rapidly changing nature of technology means that our “state of the art” technology might not be state of the art for very long. Based on these two facts, we believe that this will be a short-term project, and that it is therefore appropriate to use a short-term interest rate in order to match the project’s maturity. Since we cannot narrow down the maturity of the project any more than this, we believe that the best interest rate to use is the short-term rate that has the added benefit of being the most risk-free – the 5.24% yield on a 3-month T-Bill. Another consideration is that the advent of the internet and technology based firms is relatively recent, so we want to reflect this in our cost of capital calculations. Market risk premium – The market premium is the excess return required by the market over the riskfree rate. To find this we would ideally utilize estimates of future market performance. Since these are unavailable, we instead make the assumption that historical data over a long period of time is a good indicator of future market performance. The average annual return of the S&P 500 from 1929 to 1996 is 12.7%. We chose this set of returns for two reasons. One, large caps are the most representative of the overall market. Two, the longest period of historic data available is the most accurate and conservative. Some might argue that the longest period includes returns from the Great Depression and should therefore not be chosen. However, the current recession, which began in early 2007, draws many parallels to the depression of the 1930’s and such events, though they do not occur often, still should be included in our analysis. Accordingly, our market risk premium is 6.4%. ~~~~~ When choosing a risk-premium, our goal is to accurately reflect the return on the market. The market return of 14.0% is the average annual return for large company stocks. Because Ameritrade is a large company, it will be best represented by this return. We are using the data from the years 1950-1996 because we believe this to be a more accurate predictor of equity returns than the averages from 1929-1996. This is because market conditions have become more stabilized as time has passed, so it is useful to exclude data from more volatile time periods. Specifically, we wish to exclude the effects of the Great Depression. Another option is to use data for small companies in order to match the high return and high risk nature of Ameritrade. Although Ameritrade’s investment may make it more risky than the average large company, the beta we have chosen already reflects that higher risk. Therefore, we have chosen to use the market return for large companies because it more accurately depicts an overall picture of the stock market and Ameritrade’s status as a large firm. After subtracting the chosen risk-free rate of 5.24% from the average large company market return of 14.0%, we estimated the market riskpremium to be 8.76%. 4) In principle, what a are re the steps for computing the ass asset et beta in the CAPM for purposes of calculating the cost of capital for a p project? roject? To control for both business and financial risk, one must use an average industry beta of firms that have similar sensitivity to business cycles to calculate the asset beta. The steps are as follows: 1) Find

a group of comparables, 2) Find the beta of the comparables based on stock returns (regression analysis), 3) Unlever the levered beta of comparables, 4) average the unlevered betas, 5) Lever the unlevered beta of your firm Steps to compute the asset beta in CAPM: 1. Plot a graph comparing the market return (x-axis) and asset return (y-axis) 2. Plot comparable companies¶ stock coordinates for each year 3. Achieve a best fit line (regression) for comparing the asset return and market return 4. Compute the slope of comparable companies¶ stock to obtain their beta 5. Use the beta as the benchmark for calculating the cost of capital for the project

5) Ameritr Ameritrade ade does not have a beta estima estimate te as the firm has been publicly tr traded aded for only a short time period. Exhibit 4 prov provides ides var various ious choices of compar comparable able firms. What compar comparable able firms do you recommend as the appro appropriate priate benchmarks for ev evaluating aluating the risk of Ameritr Ameritrade’ ade’ ade’ss planned adv advertising ertising and technology inve investments? stments? Since there is insufficient historical trading data to calculate Ameritrade’s own beta estimate, the asset betas of comparable firms can be used. Firms in the same industry would be ideal choices, as they are by definition classed similarly in their operations and are therefore exposed to similar risks and projects. As a discount broker, Ameritrade’s largely transaction-based revenues are exposed to the seasonal stock market fluctuations, which investment services and full -service brokers would buffer through other operations such as advisory. Therefore, only discount brokers should be included in evaluating Ameritrade’s beta. The comparable firms selected for this purpose are Charles Schwab, Quick and Reilly, and Waterhouse. E-Trade, despite being classified as a discount broker, is deemed unsuitable due to confusion of classification and an insignificant sample set of data from which to estimate a beta.

6) Using the stock price and ret returns urns data in Exhibit 5 and 6, and the cap capital ital structure informatio information n in Exhibit 4, calculate th the e asset betas for the compar compara able firms. The levered betas are as follows: Charles Schwab Beta = 2.3012, Quick and Reilly Beta = 2.0505, and Waterhouse = 1.2781. 7) How should Joe Ricke Ricketts, tts, the CEO of Ameritr Ameritrade, ade, view the cost of capital estimate yo you u have calculated? The cost of capital at Ameritrade was calculated using the 10 yr treasury rate, the 10 yr average annual S&P 500 return, the relevered avg industry beta and the cost of debt. The cost of capital came to 16.9%. The high rate is attributed to the fact that Ameritrade is very sensitive to changes in the market. All of the revenues are linked to stock market activity and performance. This high cost of capital, which can be used as a discount rate in NPV analysis and viewed as the required return for investors will help determine whether projects are economically viable. Ameritrade’s WACC would have been higher if it had long-term debt on its balance sheet....