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Cost of Capital at Ameritrade

Ameritrade formed in 1971, was the pioneer in the deep-discount brokerage sector and also the first to offer
many new services that changed the way individual investors managed their portfolio. The average ROE during 1975
to 1996 was 40% all year. In 1997, Ameritrade raised $22.5 million in public offering to continue its long tradition of
technology enhancement and invest in branding.
Ameritrades main revenue sources were directly linked to stock market. Of its revenue were from
transaction and net interest. Investor generally curtailed trading activity and their borrowing in response to sustained
downward movements in the stock market. A substantial decline in the stock market could therefore lead to a steep
decline in Ameritrades brokerage commission and net interest.
Joe Ricketts, Chairman and CEO of Ameritrade, wanted to improve the companys competitive position in
deep-discount brokerage by taking advantage of emerging economies of scale. This required Ameritrade to grow its
customer base by substantial investments in technology to improve service and capacity, advertising and price
cutting. Large expenditures required to implement this strategy.
Ameritrade decided to offering low cost by reduced commissions from $29.95 to $8.00 per trade for all
internet market. There were no major player implementing low brokerage cost strategy even consumer are mostly
price sensitive. In addition, up to $100M budget would spend on technology enhancements. This strategy believed to
prevent system outages and increase trade execution speed. Advertising budget would also increase to $155M for
1998 and 1999 fiscal year combined.
To gauge the impact of Rickettss plan in this substantial investment, some accounting for the projects risk
is needed. Value can only created if the investment returned more than it cost and the investors would demand a
return that reflected the riskiness of their investment. Ricketts believed that CEO should tried to maximize
shareholder value, and he would invested if the expected returns on investment were greater than the cost of capital,
even there was a chance of bankrupting the firm. Ricketts was expected a return on the order of 30% to 50 % but
some members were not optimistic given an estimation of merely 10% to 15% for the return.
Furthermore, a CS First Boston analyst report employed a discount rate of 12% when evaluating Ameritrade
while Ameritrade CFO often used a 15% discount rate. In addition, the managers felt that a discount rate of 8-9% was
appropriate to the future profit estimates. A consultant was then hired by the CEO of Ameritrade to estimate the cost
of capital for Ameritrade. Another issue was Ameritrade was not clarify itself in the industry if it was a discount
brokerage firm or a technology/internet firm because ABN-AMRO valued Ameritrade as an internet firm.

Marriott Corporation: The Cost of Capital (Abridged)


Marriott Corporation began in 1927 and it is now the leading lodging and food service companies in the U.S..
Marriotts profits were $223M on sales of $6.5 billion and its ROE stood at 22%. Sales and earnings per share
doubled over the previous four years. Marriott had three major lines of business: lodging operations, contract services
and restaurants. In 1987, Marriott developed more than $1 billion worth of hotel properties and sold the hotel assets
to limited partners while retaining operating control as the general partner under a long-term management contract.
The overhead cost of managing the hotel often covered by management fees, which was 3% of revenues
plus 20% of the profits before depreciation and debt service. The 20% of profits before depreciation and debt service
often stand aside until investors earned a pre-specified return.
Marriott used discounted cash flow techniques to evaluate potential investments. The hurdle rate for projects
was based on market interest rates, project risk, and estimates of risk premiums. Thus the cash flow forecasts
incorporated standard company wide assumptions that instilled some consistency across projects. By 1987, Marriott
had about $2.5B of debt, 59% of its total capital. It used an interest coverage target instead of a target debt-to-equity
ratio to determined the amount of debt in its capital structure. Also, Marriott calculated its warranted equity value by
discounting the firms equity cash flows by its equity cost of capital and repurchase stock that below the value. In
1987, Marriott repurchased 13.6 million shares of its common stock for $429M.
Marriott used CAPM to estimate the cost of equity. Marriotts beta was 1.11 by calculated five years of
monthly stock returns. While debt capacity, debt cost, and equity cost consistent with the amount of debt were used
in WACC to determined Marriotts opportunity cost of capital for the corporation as a whole and for each division. In
addition, Marriott determined each division based on the sensitivity of the divisions cash flows to interest rate
changes. The interest rate on floating rate debt changed as interest rates changed. Marriotts debt cost for each
division estimated as an independent company and expected to pay a spread above the current government bond
rates. Marriott used cost of long-term debt for its lodging cost-of-capital calculations while shorter-term debt as the
cost of debt for its restaurant and contract services divisions.
Divisional hurdle rates at Marriott would have a significant impact on the firms financial and operating
strategies. Firstly, Marriotts beta was a weighted average of the betas of its different lines of business. Secondly,
leverage affected beta. Debt would increase its equity beta even if the riskiness of the firms assets remained
unchanged, because the safest cash flows went to the debt holders.

Dell's Working Capital


Dell founded in 1984 focused on designed, manufactured, sold and serviced high performance PCs
compatible with industry standards. Dell then began to market and sell its own brand PCs through phone order and
shipped directly to customers. Dell combined its low cost sales/distribution model with the build-to-order model that
differentiate itself in the industry.
Dells build-to-order model yielded low finished goods inventory comparing to its industry leaders. Dell
maintained an inventory of components and the cost of individual components comprised about 80% of the cost of a
PC. However, components prices fell 30% as new technology replaced old. Dell ordered components from 80
suppliers based on sales forecast. Order delivered on daily basis.
Dell was too small to survive a consolidation and had only 1% of the U.S. PC markets share by 1990. Dell
was then growing after the company expanded its indirect distribution channel by adding other mass-market retailers.
In addition, Dell continued aggressive pursuit of foreign markets, relying on retailers to distribute Dell product. Its
annual sales increased by 268% within two years, compared to industry growth of 5%, and moved Dell into the top
five in worldwide market share.
However, Dells profit margin fell to 2% for the first quarter, ending May 2, 1993 and a loss of $76 M in the
second quarter in August 1993. The loss was tied to $71 million in charges relating to the sell-off of excess inventory
and the cost of scrapping a disappointing notebook computer line. Analysts assumed Dell could last a year with $32M
in cash and cash equivalents, but many wondered if Dell had enough resources to compete.
Dell then focused on liquidity, profitability, and growth and exited the low margin indirect retail channel. Late
in 1995, Dell instituted goals on ROIC and CCC to improve its internal systems for forecasting, reporting, and
inventory control. These changes fueled the companys recovery. Dell was able to offer faster systems at the same
price while rivals marketed older system and maintains its low finished goods inventory.
January 31, 1996, Dell reported revenue of $5.3 billion with net income of $272M, or 5.1% of sales.
Revenue was up 52% over the prior year compared with an industry increase of 31%. In addition, Dell was predicted
to again outpace the industrys growth. However, Dell was suffered somewhat from component shortages at the
same year.

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