Cost of Capital at Ameritrade

CAPM

Cost of Capital at Ameritrade

Introduction to Case

Calculate CAPM

Calculate WACC

Company Background

Ameritrade is formed in 1971

pioneer in the deep-discount brokerage

sector.

In Mar 1997, Ameritrade raised $22.5

million in IPO

Company Background

- Source of revenue from Transaction

and Net interest

Business Question
Joe Ricketts (CEO) is thinking cut cost,
invest in advertise or invest in
technology
- Expect return 30-50%
- Expect return 10-15%
What type of Ameritrade Business?

Who are Ameritrades Competitors

E*Trade

Waterhouse Investor Service

Charles Schwab

Quick & Reilly

Other Information that we have?

Ameritrade Annual Income, Balance

sheet

Capital Market return data

Ameritrade & Competitors Stock price

Stock return from NYSE

What do we need to answer

question

CAPM (Capital Asset Pricing Model)

WACC (Weighted Average Cost of Capital)

Risk Free Rate

Beta (unleverage)
Risk Premium
Expected Market Return

E/V ratio
Re
Rd
D/V

What do we need to answer

question
CAPM (Capital Asset Pricing Model)
WACC (Weighted Average Cost of Capital)

CAPM - Capital Asset Pricing Model

Ke = Rf + B (Rm-Rf)
Risk free rate
Beta
Expect Market return
Market risk premium (Rm-Rf)

CAPM - Capital Asset Pricing Model

Risk free rate
We pick up 30-years bonds
Rf = 6.61%
Why?
Ameritrade is going to make a substantial investment
in technology
Ameritrades mission is to be the largest brokerage
firm worldwide(Long term investment)

CAPM - Capital Asset Pricing Model

Market Risk Premium
Historic Average Total Annual Returns on US
government securities and Common Stocks(Exhibit 3)

We consider Ameritrade is a large company

- in 1997, Ameritrade(NASDAQ: AMTD) raised 22.5
million in an initial public offering

CAPM - Capital Asset Pricing Model

Historic Average Total Annual Returns on US
government securities and Common Stocks
Rm (1950-1996) = 14%
Rm (1929- 1996) = 12.7%
Market return Rm = 14% (More recent)
Market Risk Premium = 14% - 6.61% =7.39%

CAPM - Capital Asset Pricing Model

Beta
Ameritrade is a new list company, we do not have
enough information about Beta
Exhibit 4 provides various choices of comparable
firms:
Charles Schwab Corp (Discount Brokerage)
E*Trade (Discount Brokerage)
Quick & Reilly Group (Discount Brokerage)
Waterhouse Investor Srvcs (Discount Brokerage)

CAPM - Capital Asset Pricing Model

Unlevered Beta
Charles Schwab
2.450843913
Quick Reilly
2.385245695
Waterhouse Investor Service 3.372739586
Average Ameritrade Beta

2.736276398

CAPM - Capital Asset Pricing Model

Risk Free Rate (30 years bond) = 6.61%
Market Risk Premium (1950-1996) = 14% - 6.61% =7.
39%
Ameritrade Beta = 2.736276398

Ke = Rf + B (Rm-Rf)
=6.61%+ 2.7 (14% - 6.61%)
=26.83%

WACC- Weighted Average Cost of Capital

Why uses WACC in this

Case?
WACC is the cost of capital of the company
WACC is a rate that a company is expected to pay
back to both shareholder and debt holders.
A New investment project should give rate of
return higher than the cost of capital

WACC- Weighted Average Cost of Capital

Find Market Value of Debt/Equity

WACC- Weighted Average Cost of Capital

35%

Assume Rd

Scenario 1
Rd = 0
Assume that debt has no relationship to
market risk

Scenario 2
Rd = 0.25*
Assume some market-related risk to corporate
debt

* Empirical studies of corporate debt returns (ref)

WACC- Weighted Average Cost of Capital

Senario 1
Cost of Capital = 7%
Senario 2
Cost of Capital = 19%
* Empirical studies of corporate debt returns (ref)

Should the company invest the new

projects?

Money that the Company

need to pay back

Expected Return of
the new investment projects