Cost of Capital at AmeritradeCAPM

Cost of Capital at Ameritrade

● Introduction to Case

● Calculate CAPM

● Calculate WACC

Company Background

● Ameritrade is formed in 1971

● pioneer in the deep-discount brokerage sector.

● In Mar 1997, Ameritrade raised $22.5 million in IPO

Company Background

● - Source of revenue from Transaction and Net interest

Business Question

● Joe Ricketts (CEO) is thinking cut cost, invest in advertise or invest in technology

- Expect return 30-50%- Expect return 10-15%

● What type of Ameritrade Business?

Who are Ameritrade’s Competitors

● E*Trade

● Waterhouse Investor Service

● Charles Schwab

● Quick & Reilly

Other Information that we have?

● Ameritrade Annual Income, Balance sheet

● Capital Market return data

● Ameritrade & Competitors Stock price

● Stock return from NYSE

What do we need to answer question● CAPM (Capital Asset Pricing Model)

◦ Risk Free Rate◦ Beta (unleverage)◦ Risk Premium◦ Expected Market Return

● WACC (Weighted Average Cost of Capital)◦ E/V ratio◦ Re◦ Rd◦ D/V

What do we need to answer question

● CAPM (Capital Asset Pricing Model)

● WACC (Weighted Average Cost of Capital)

CAPM - Capital Asset Pricing Model

Ke = Rf + B (Rm-Rf)

◦ Risk free rate

◦ Beta

◦ Expect Market return

◦ Market risk premium (Rm-Rf)

CAPM - Capital Asset Pricing Model

Risk free rate We pick up 30-years bonds Rf = 6.61% Why? Ameritrade is going to make a substantial investment in technology

Ameritrade’s mission is to be the largest brokerage firm worldwide(Long term investment)

CAPM - Capital Asset Pricing Model

Market Risk PremiumHistoric Average Total Annual Returns on US government securities and Common Stocks(Exhibit 3)

We consider Ameritrade is a large company - in 1997, Ameritrade(NASDAQ: AMTD) raised 22.5 million in an initial public offering

CAPM - Capital Asset Pricing Model

Historic Average Total Annual Returns on US government securities and Common Stocks

Rm (1950-1996) = 14% Rm (1929- 1996) = 12.7%

Market return Rm = 14% (More recent) Market Risk Premium = 14% - 6.61% =7.39%

CAPM - Capital Asset Pricing Model

BetaAmeritrade is a new list company, we do not have enough information about Beta

Exhibit 4 provides various choices of comparable firms:

Charles Schwab Corp (Discount Brokerage) E*Trade (Discount Brokerage)

Quick & Reilly Group (Discount Brokerage) Waterhouse Investor Srvcs (Discount Brokerage)

CAPM - Capital Asset Pricing Model

Unlevered Beta

Charles Schwab 2.450843913Quick Reilly 2.385245695Waterhouse Investor Service 3.372739586

Average Ameritrade Beta 2.736276398

CAPM - Capital Asset Pricing Model

Risk Free Rate (30 years bond) = 6.61%Market Risk Premium (1950-1996) = 14% - 6.61% =7.39%Ameritrade Beta = 2.736276398

Ke = Rf + B (Rm-Rf) =6.61%+ 2.7 (14% - 6.61%) =26.83%

● WACC is the cost of capital of the company ● WACC is a rate that a company is expected to pay

back to both shareholder and debt holders.

● A New investment project should give rate of return higher than the cost of capital

Why uses WACC in this Case?

WACC- Weighted Average Cost of Capital

WACC- Weighted Average Cost of Capital

Find Market Value of Debt/Equity

35%

WACC- Weighted Average Cost of Capital

●Scenario 1◦Rd = 0 ⚫Assume that debt has no relationship to market risk

●Scenario 2◦Rd = 0.25*⚫Assume some market-related risk to corporate debt

* Empirical studies of corporate debt returns (ref)

Assume Rd

* Empirical studies of corporate debt returns (ref)

●Senario 1●Cost of Capital = 7%●Senario 2●Cost of Capital = 19%

WACC- Weighted Average Cost of Capital

Money that the Company need to pay back

Expected Return of the new investment projects

Should the company invest the new projects?