Cost Of Capital At Ameritrade Case Study Solution
Introduction and Background Information
Ameritrade Holding Corp. is a low-discount brokerage firm, whose management is currently planning to make a major investments in the company’s marketing and technology development. The reason behind this initiative is to improve the company’s performance and its competitive position by taking the advantage of potential economies of scale.(Stafford, 2001).
To analyze the strategic business opportunities available; the management must assess whether these investments are capable of generating positive future cash flows for the business, or not. Currently, the company’s CEO uses 15 percent of the cost of capital to analyze these projects, but the company’s management estimates the cost to be around 8 to 9 percent, while research analysts say it should be around 12 percent.
Problem Statement
The main problem for the business is the difference in the cost of capital used to evaluate the business projects. Therefore, the management should determine the cost of capital, which is required to evaluate the project.
Analysis
Appropriate Comparable Firms
It is concluded that Charles Schwab, Quick and Reilly and Water house should be used as appropriate benchmarks to assess the Ameritrade’s risk, as discount brokers also derive most of their income from the brokerage firm, and their business model is similar to Ameritrade.
Estimation of Risk-Free Interest Rate and Market Risk Premium
To determine the applicable risk-free interest rate; it should be taken into account that these items are long-term, so both the long-term as well as the current interest rate should be used. Therefore, the risk-free interest rate is estimated at 30 years for government bonds, which is 6.6%.
For the market as a whole; the average value of shares of small and large companies, is taken as a risk premium. Therefore, the estimated value of market risk premium is 15.9 percent ((14 percent + 17.8 percent) / 2) and the market risk premium is 15.9 percent -6.69 percent = 9.29 percent.
CAPM Element Beta’sCalculation Steps
Asset beta is the weighted average beta of debt and equity. To calculate this amount, we can assume that the debt beta has 0.25percent, with the market risk of the firm. Then, by eliminating the effect of the company’s financial risks; the beta of the asset is calculated by releasing the beta from the company’s equity. The formula used to calculate the beta asset is Beta asset = beta capital * (equity / (debt (1 – tax rate) + equity)) + beta debt * ((debt (1 – tax rate)) / (debt (1 – tax rate) + equity)).
Assets Beta of Company’s Comparable Firms
The beta of the assets of comparable companies is obtained by comparing the monthly profits of these companies with the market profits of the New York Stock Exchange: the American Stock Exchange and the NASDAQ. Then use the current debt / market value ratio given in the table, to reduce the leverage of these betas. The calculations are included in the Exhibit 1 of the document.
Factors Need to be Considered by Company’s Management
The company’s management should conduct cost-benefit and risk analyses, and compare the cost of investing in technology upgrades and advertising with the returns generated by these projects. The effect of the price reduction on the cash flow of these projects should also be taken under consideration. The three intentions, including: technological advances, increased advertising and strong price reductions, are believed to be closely interlinked and should be analyzed in context. The company’s management should determine an appropriate discount rate for the project in order to avoid discrepancies in the calculation of the net present value and to forecast the expected return for investors.
Recommendation to the CEO
By averaging the assets beta of the comparable companies and then touching on Ameritrade’s debt / equity ratio again; the cost of equity is 20.83 percent. Since the company’s financial statements do not include the long-term debt; it can be assumed that the company’s cost of capital is the company’s weighted average cost of capital.
From the information provided in the case; it can be seen that there are different views on Ameritrade’s business types and discount rates, so the types of investors are also different. Therefore, we recommend that the CEO should take into account the different situations regarding the cost of capital and only accept projects that produce a better return on capital..............
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