Cost of Capital at Ameritrade Case Study Analysis
Estimates of Risk Free Rate and Market Risk Premium:
When estimating the risk free rate (RFR) which is to be used in the calculation of the required rate of return, it is considered that the projects are for the long term in the future therefore, long term (30 year bond) risk free rate (RFR) should be used. Hence, it is estimated that the risk free rate is the rate for 30 year government securities, which is 6.61 percent for the calculation of the two upcoming project’s required rate of return.
To consider a broader market, the expected annual market return of the large company stockshas been taken,which is 14 percent (average). Therefore, the market risk premium is estimated to be 7.39 percent,which is calculated by subtracting the risk free rate of 6.61 percent from the expected market return of 14 percent.
Betas for Comparable Firms and Ameritrade:
The betas for comparable firms and Ameritrade Corporation have been calculated by using the covariance and variance formulas that will be calculated after measuring the stock returns relative to the market returns and the movement in stock returns from its mean respectively.
Cost of Equity:
Cost of equity for Ameritrade’s two upcoming projects in order to evaluate the strategy that whetherthese two upcoming projects will generatesufficient cash flows for the company or not, has been calculated by using these two methods, in which two different betas are used. In the first method, the average equity beta has been taken of four Ameritrade’s comparable firms, which is 0.12 and gives the cost of equity around 7.52 percent.While in the second method, the own company’s equity beta has been taken by using the covariance and variance formulas that will be calculated after measuring the Ameritrade’s stock returns related to the market returns and the movement in stock returns from its mean respectively, which is 0.13 and gives the cost of equity around 7.57 percent. In short, the cost of equity for the two upcoming projects of Ameritrade’s will be in between of 7.52 percent to 7.57 percent.
Weighted Average Cost of Capital (WACC):
In order to evaluate the strategy that whether these two upcoming projects will generate the sufficient cash flows for the company or not, Weighted Average Cost of Capital (WACC) for the Ameritrade’s two upcoming projectshas been calculating by using the two methodsin which two different costs of equities are used. In the first method, 7.52 percent cost of equity has been used, which gives the 4.43 percent Weighted Average Cost of Capital (WACC) while in the second method, the 7.57 percent cost of equity has been used which also gives the 4.43 percent Weighted Average Cost of Capital (WACC). In short, the Weighted Average Cost of Capital (WACC) for the two upcoming projects of Ameritrade’s is 4.43 percent.
Recommendations
By using the average of the equity betas of the comparable companies, a range of cost of equity from 7.52 percent to 7.57 percent is calculated. Since the financial statements of the company do not contain any long term debt, it is assumed that the company is using the intermediate bond rates for the calculation ofWeighted Average Cost of Capital (WACC).
By the information provided in the case, it can be seen that there are differing views regarding the type of business and discount rate for Ameritrade, and so there can be different types of investors too. Therefore, it is recommended that the CEO should take into account multiple scenarios regarding the cost of capital, and only accept the projects that would be able to generate returns better than the company’s cost of capital, which is 4.43 percent...........................
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