THIAGARAJAR SCHOOL OF MANAGEMENT (TSM)

A REPORT ON ESTIMATING THE

COST OF CAPITAL OF AMERITRADE

GROUP MEMBERS

Anish Fatima N - 1913017

Anjali Rajesh - 1913019
Aravind A R - 1913021
Armaan Saaliqh M - 1913022
Swaminathan S - 1913101

Submitted
To
Dr. Rana Pratap
CASE SUMMARY

Ameritrade, a stock brokerage company, was headed by Joe Ricketts in

1971.Their main source of income was from transactions and net interest. They became the
first to offer online trading and phone trading.

Joe Ricketts planned to increase the revenue by targeting the self-directed investors. The
strategy for increasing the revenue included price cutting, technology enhancements and
increased advertising. In order to increase the revenue, he reduced the share price to bring the
new customers into the market. He also invested in the improvement of the technology so that
it could enhance the trade execution speed. The budget for advertising was increased to $155
million for the years 1998-99. Ricketts expected return of investment to be 30% to 50% but
some of his team members expected nearly 10-15% and told that Ricketts expectation was high.

The CS First Boston analysed the company with 12% discount as against 15% discount rate
with what the company has calculated. They need to find the return of capital by CAPM model
so that they can find out whether the project can be implemented.

Question 1:

What factors should Ameritrade management consider when evaluating the proposed
advertising program and technology upgrades? Why?

• The management should mainly focus on the cost of capital to decide upon the
technology upgrades and an advertising program.
• It is also important for the management to consider net present value of cash flows
which the company needs to discount the cash flows at a proper rate not affecting the
returns of the company.
• Particularly Ameritrade also has to do analysis on risk management in addition to the
NPV and future cash flows of the company.

Question 2:

How can the Capital Asset Pricing Model be used to estimate the cost of capital for a real
(not financial) investment decision?

• It is used for estimating the cost of the shareholders’ equity and it tells the relationship
between the systematic risk and the return of the assets.
• It can be used for calculating the portfolio of the shares and their risks.
 • The risk mainly comprises of two things: risk free rate and market risk premium which
helps in analysing the risk associated with the return on the various assets of the market.

Question 3:

What is the estimate of risk-free rate that should be employed in calculating the cost of
capital for Ameritrade?

• We considered the Risk- free rate, Rf of 6.22% to calculate the cost of capital (from
exhibit 3)
• The risk-free rate is needed to calculate the investment in new technology and also, due
to the fact that technology changes rapidly, in this case we considered the rate of 5-year
bond as the value of the company shares. So, the Rf value is taken as 6.22%

Question 4:

What is the estimate of market risk premium that should be employed in calculating the
cost of capital for Ameritrade?

• To estimate the market risk premium – risk free rate and market return has been taken
into account to calculate the cost of capital.
• Already the risk-free rate has been estimated as 6.22% and hence market return is
needed to estimate the cost of Ameritrade.
• Market risk premium is estimated by subtracting the risk-free rate from the market
return.
• In this case, the return on large company stock during 1950-1996 has been considered
as the market return which is equal to 14%
• Therefore, the market risk premium is calculated using the formula of:
= Market return – Risk free rate
= 14% - 6.22%
= 7.78%
• Hence, the market risk is taken for large company stock from exhibit 3 of the case as
the stock of Ameritrade comes under large capital company and the risk premium is
estimated as 7.78%
Question 5:

In principal, what are the steps for computing the asset beta in the CAPM for purposes
of calculating the cost of capital for a project?
The regression analysis is performed between the company and the market to calculate
the cost of capital for Ameritrade.

The formula to calculate the monthly returns is given below:

Stock’s Monthly returns:
For dividends - Pt−Pt−1+Dt/Pt−1
For stock splits - Pt−Pt−1+𝑥𝑦Dt/Pt−1 (x for y).

Ameritrade - 1992-1996
CAPM
Rf (5 year bond) 6.22%
Rm (Large 14.00%
Company stock)
Risk Premium (Rm- 7.78%
Rf)
Cost of Equity 26.44%
(CAPM)

Thus, the cost of capital estimated as 26.44%

Question 6:

Ameritrade doesn’t have a beta estimate as the firm has been publicly traded for only a
short time period. Exhibit 4 provides various choices of comparable firms. What
comparable firms do you recommend as the appropriate benchmarks for evaluating the
risk of Ameritrade’s planned advertising and technology investments?

Comparable firms:

The firms have been taken here to evaluate the risk of Ameritrade are:

• Charles Schwab
• Quick and Reilly
• Waterhouse

Ameritrade choice for beta value will be from Charles company as it has the
same profile as that of Ameritrade with similar market capitalisation and also Quick and
 Reilly, Water house investors has been compared since it comes under the discount
brokerage firms.

For Quick & Reilly:

Quick & Reilly

Quick & Reilly Linear (Quick & Reilly) y = 2.3603x - 0.0042
R² = 0.2893
0.3
Stock returns

0.2
0.1
0
-0.060 -0.040 -0.020 -0.10.000 0.020 0.040 0.060

-0.2
-0.3
Market returns

For Charles:

Charles schwab
Charles schwab Linear (Charles schwab) y = 2.2585x + 0.0036
R² = 0.2237
Stock returns

0.400

0.200

0.000
-0.060 -0.040 -0.020 0.000 0.020 0.040 0.060
-0.200

-0.400
Market returns

For Waterhouse investor services:

Waterhouse investor services

y = 3.1769x + 0.006
R² = 0.2212
Waterhouse investor services
Linear (Waterhouse investor services)
0.6
Stock returns

0.4
0.2
0
-0.060 -0.040 -0.020 -0.20.000 0.020 0.040 0.060

-0.4
Market returns
Question 7:

Using the stock price and returns data in Exhibit 4 and 5, and the capital structure
information in Exhibit 3, calculate asset betas for comparable firms

ASSET BETA OF COMPARABLE FIRMS

Beta Asset of BETA

comparable firms
Charles 2.08
Quick & Reilly N/A
Waterhouse investor 1.97
services

Question 8:

How should Joe Ricketts, the CEO of Ameritrade, view the cost of capital estimate you
have calculated?

• As the expected return is 26% which is less than the expected return of joe ricketts
which is 30-50 % , Hence he would take up the project
• But the management does not go with the solution as their expected return is 10-15 %.
• Hence joe has to take the risk of taking up the project with long term growth of the
company by even taking the long - term debt from others.