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# Cost of Capital at Ameritrade Essay

The cost of capital is the cost to the company for borrowing money. The cost of capital can be assessed by looking at the cost to borrow funds from investors, banks, or even internally through retained earnings. It includes interest rates and other costs associated with financing an investment project. This paper will provide a brief overview on what cost of capital is and how it affects your investments.

## Essay 1

### How CAPM can be used to estimate the cost of capital for real investment decisions

For example, a major difference between real and financial investment is that real investment decisions are concerned with tangible assets rather than financial instruments. Financial investments are typically traded on stock exchanges, making it simple to predict the prospective returns. In comparison, real investment selections involve genuine resources such as land, technology, people, and other tangible assets. These things make calculating the required returns difficult.

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The Capital Asset Pricing Model (CAPM) is a method for determining how much an investment will be worth at the end of its life. It explains that investors must be compensated for taking a risk as well as keeping their money for a specified amount of time. The CAPM equation is:

Expected Return = Risk-Free Rate + ß(Expected market return-Risk Free rate)

In this instance, the letter b represents the Asset Beta. This statistic depicts how readily the asset’s returns respond to changes in market returns. A large ß indicates that the asset’s returns are strongly linked to market returns, whereas a tiny ß suggests that they are not. The estimated Asset Beta of Ameritrade is 2.06, according to this example.

The amount needed for this is severe. It reflects the fact that the potential profits of the proposed investment are highly reliant on market returns. This is a very dangerous venture. As a result, investors will be required to pay a high premium to assume this risk. This is reflected in the high cost of capital (22%).

The Cost of Capital may be estimated using CAPM if the Asset Beta, Expected Market Return, and Risk-Free Rate are known. In Ameritrade’s case, the asset beta must be estimated from comparable firms. The risk-free rate is taken as the return on government bonds with a term equal to or greater than the planned investment period.

Assume a scenario: The company has decided to borrow \$1 million and invest it in the stock market. It will be returning that money to investors after 10 years, when its debt is paid off (with amazing interest rates). Using historical averages, I determined the Risk-Free Rate for this investment to be 6.61 percent. This is the Annualized Yielding to Maturity on 30-year government bonds. The reason I selected 30-year bonds rather than shorter-term bonds is because this is a long-term investing decision. The firm plans to spend a lot of money on this project while expecting returns for an equal length of time. As a result, this is the ideal proxy for the Risk-Free rate.

The Market Risk premium is 7.2 percent, according to my calculation. I got it by calculating the gap between long-term bonds’ and large company stock’s Average Annual Returns from 1929 through 1996. Because the later period is shorter than the earlier one, I chose 1926-1996 as opposed to 1950-1996. As a result, I expect 1926-1996 to provide more accurate results than 1950-1996.

### Computation

Large Company Stocks- Long Term Bonds

= 12.7% – 5.5%

=7.2%

Steps for computing the asset beta for purposes of calculating the cost of capital
The first step in the procedure is to calculate each firm’s or asset’s monthly return. The information on stock prices in Exhibit 5 is useful for this purpose. The monthly returns are based on the stock price, time differences, and dividend payments. For a typical month with no stock split, the formula for calculating returns is as follows:

Return = (Pt+1 – Pt + Divt+1)/Pt

In the case of a stock split, the formula is modified somewhat to reflect this.

The equity beta may now be calculated using the VW NYSE or EW NYSE. I selected the VW NYSE because it is one of my favorite stock exchanges. The regression analysis of both the monthly returns( x) and the VW NYSE (y) is utilized to calculate beta in this approach. To perform this study, I used Excel’s SLOPE built-in function. I concentrated on the most recent five years of data when calculating the equity beta for each comparable firm.

To access the Asset Betas for each company, un-gear the Equity Betas. The Debt-Value ratios are used to accomplish this. They were given in Exhibit 4 in this example. Estimate the firm’s (Ameritrade) asset beta by taking the average of all comparable Asset Betas after ungluing all of the Equity Betas. i.e

### Computation

Charles Schwab-2.116

Quick & Reily-1.7879

Waterhouse Investor Services-2.3038

Average= (2.116+1.7879+2.3038)/3 =2.06931

Firms recommended as benchmarks in estimating the cost of capital. Exhibit 4 depicts three distinct types of businesses. The first group is made up of the Discount Brokerage firms Quick & Reilly Group, Charles Schwab, Waterhouse Investor Services, and E*Trade. The second group is comprised of internet firms Mecklermedia, Netscape, and Yahoo. The third category is made up of Investment service companies A G Edwards, Bear Stearns (for broker-dealers), Lehman Brothers (for broker-dealers), Merrill Lynch & Co (for investment advisers/advisers), Morgan Stanley Dean Witter (for business researchers only; no commission-based accounts).

It is important to find a comparable firm that has a similar risk profile. The Ameritrade firms are quite different from the internet firms. They make most of their money through advertisements, whereas Ameritrade relies on the discount brokerage for 68% of its income. These businesses do not receive any revenue from the discount broker.

Belts and ties are not a good fit for this purpose because they don’t provide enough support. Discount brokerage services, in particular, generate a significant amount of money for investment service businesses. The proportion of discount brokerage income as compared to other sources, on the other hand, is modest. In some situations, it may be as low as 12%. Because of this information, they are unable to serve as comparable firms.

The finest group is the discount brokerages. They rely on transaction fees, just like Ameritrade. The only distinction is in the types of transactions. As a result, given that they operate in the same industry, these sorts of transactions should be seen as comparable risks. I would propose using these firms as a benchmark for planned investments.

## Essay 2

In mid-1997, Joe Ricketts, the founder and chief executive of Ameritrade Holding Corporation, wanted to improve his firm’s competitive position in deep-discount brokerage1 by taking advantage of emerging economies of scale. The strategy’s success depended on Ameritrade’s ability to expand its client base. To increase customer awareness, the company would need to make significant investments in technology to enhance service and capacity as well as advertising.

Ricketts needed an estimate of the project’s risk in order to evaluate whether the plan would justify the expenditure. The strategy would need substantial investment compared to Ameritrade’s present capital. Ricketts required a probability estimate for the project in order to assess whether the plan would be profitable enough to merit the investment.

### Company Background

Customers’ cash accumulated in compliance with federal requirements in short-term marketable securities was invested to produce interest income. Interest payments were made to customers based on credit balances maintained in brokerage accounts, offsetting the interest earned.

Virtually all of Ameritrade’s income was derived from the stock market. In response to sustained declines in the stock market, investors generally reduced trading activity and borrowing. Trading activity fell by more than 20% in 1988 following the October 19, 1987, stock market crash. As a result of this collapse, broker commissions and interest revenues would most likely plummet.

Full-service brokers were less responsive to market changes than deep-discount brokers like Ameritrade. Asset management fees paid by full-service brokerages helped to protect the income stream from market drops. Merrill Lynch, for example, diversified its revenue stream by entering into investment banking deals such as mergers and security underwritings.

## Essay 3

Ameritrade was founded in 1971 and is the world’s first deep-discount brokerage firm. In March 1997, Ameritrade floated on the stock market for \$22.5 million. Ameritrade’s management are considering significant technology and marketing expenditures, but they are unsure of the appropriate cost of capital.

We don’t have Ameritrade’s beta, so we’ll need to look for comparable businesses with which to compute betas. There are several possibilities in this case. Which firms are the most appropriate? As a result, the risk proportion is influenced by the percentage of revenue generated from transactions and interest (brokerage activities).

CAPM = rf + B x (rm –rf)

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

Since the project will require substantial technology and advertising expenditures as well as future cash flows, we can assume that it is a long-term investment, therefore we should use long-term rates and not historical rates. I’ll utilize a 10-year time horizon for this example, so the current 10 year interest rate is: 6.34 percent

What is the market risk premium that should be used in Ameritrade’s cost of capital calculation?

We should use the difference between small stock returns (Ameritrade has a market capitalization of \$273,127,000 as of August 29, 1997) and long-term government bond returns: We choose the more recent historical data as it is less modern and thus less dependable with new technology.

Risk premium (1950-1996) = 17.8% – 6.0% = 11.8%

What do we use to compute betas? We require the company’s periodic returns and the general market index’s returns in order to compute betas. We regress both return rates, obtaining the slope of the line, which is our Beta. We should utilize projections for the previous five years.

## Essay 4

Mr. Ricketts, as CEO, thinks it is his duty to maximize shareholder value by accepting any project with an expected return on investment that exceeds the cost of capital. As a result, the main things Ameritrade management should consider are the projected return on investment for the initiative and how it compares to the project’s cost of capital.

Other things to think about include: how market fluctuations will affect the projected return on investment, the project’s payback period (because initial expenditures may be large, Ameritrade might find itself in financial difficulty if outcomes are not seen soon), and the unique risk that comes with being the major player in their price range.

This might include: The likelihood that price reductions in the near future may enable rivals to acquire the same technology for a fraction of the cost, as well as other factors such as market share increases and potential benefits (such as increased competition among suppliers, lower prices due to economies of scale, greater bargaining power because there are more competitors).

What is the formula for computing the cost of capital for real (nonfinancial) business investment decisions using the Capital Asset Pricing Model (CAPM)? The return on a project must be greater than what the company could earn by investing an identical amount of money in financial investments.

## Essay 5

What are the expenses of capital for Ameritrade? What factors should Ameritrade management consider while evaluating the proposed advertising program and technological upgrades? Why? Mr. Ricketts contends that as CEO, his duty is to achieve maximum shareholder value by accepting any project with a greater expected return than the cost of capital.

The projected return on investment for the project and how it compares to the project’s cost of capital are two major questions that Ameritrade management should consider. Other things to consider include: How market swings will impact the estimated return on investment, as well as the payback period of the project (the project will require a substantial initial investment).

The main disadvantage is the high cost. While Ameritrade’s growth prospects may be limited, it offers a number of benefits. The business presently operates in a price range with no competitors (which means if they don’t see results fast enough, they could get into financial trouble).

The drawbacks of being the world’s largest company in their price range, and the threats involved with being “the first adopter” of cutting-edge technology (unanticipated technical problems, risk that current price reductions will enable rivals to obtain same technology at a much cheaper rate).

The possible benefits of gaining a larger market share on future projects, as well as the influence of previous advertising campaigns. How can you use the Capital Asset Pricing Model (CAPM) to calculate the cost of capital for real (nonfinancial) investment alternatives? Because it provides a yardstick against which financial decisions may be measured, the CAPM is an essential instrument when making true (nonfinancial) investment choices.

A company’s return on investment for a project must be greater than the amount of money it may make investing the same amount of money in financial assets. What is the risk-free rate that should be used to calculate cost of capital using the CAPM? Explain. The 5% risk-free rate we chose is based on a 3-month T-Bill with a current yield of 24%. We selected this rate because it is the most basic risk-free rate available.

“Investment decisions are known for their complexity, yet there is plenty of research done to aid decision-making. Given the necessary knowledge, investment strategies are fairly simple to comprehend. Market fluctuations require immediate reaction because executing a long-term strategy entails considerable risk at this stage.”

A company’s return on a project must be greater than what it can gain by putting the same amount of money into financial assets. What is the risk-free rate to use in computing cost of capital using the CAPM? Explain. The 5% risk-free rate that we chose is the most pure risk-free rate available because it is currently yielding 3 months’ worth of T-Bills at 24%.