Ameritrade Case

1. Briefly describe the project that Ameritrade is considering.

Ameritrade is considering using proceeds from an IPO to invest in technology upgrades and fund an advertising and brand recognition campaign. The goal is to become the largest online deep-discount broker. This project would allow the company to charge far lower commissions for their target market, which is individual, self-directed investors. This project is particularly risky as the new technology would need to be reliable and able to handle large amounts of trades, as their target market would ideally be trading more often based on lower commissions. If the technology was faulty, customers could quickly switch to an alternative discount brokerage.

2. Why is cost of capital important? What factors determine cost of capital?

Cost of capital reflects a firm’s opportunity cost. It is the rate of return an investor could receive on a comparable investment with equal risk and term. Cost of capital is determined by the risk free rate and an adjustment for the risk of the investment.. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. Once the cost of capital is met, the company can generate value for a particular project.

3. Which of these comparable firms are appropriate to use to determine the beta of Ameritrade’s planned investments? Why?

Ameritrade is purely in the business of discount brokerage and has no long-term debt. If you classify both transaction income and net interest as brokerage revenue, brokerage revenue constitutes 91% (($51.9 m +18.2 m) / 77.2m) of total revenues for Ameritrade in 1997. Another important thing to note is that Ameritrade revenues were directly linked to the stock market. This eliminates full-service brokerage firms from the comparable conversation as those were able to show much more stable revenue streams during market downturns.

4. Estimate the CAPM beta.

(i) Scenario 1

We use brokerage firms as comparable in this scenario. The four firms that most closely match this revenue mix from Exhibit 4 are Charles Schwab (82%), E*Trade (95%), Quick & Reilly Group (81%) and Waterhouse Investor Srvcs (99%). Because E*Trade has only 13 months of data, we will use the other three firms as comparable. Also, we assume the debt of brokerage firms are equivalent to Baa rated corporate bonds which has Beta of 0.23.

Charles Schwab Quick & Reilly Waterhouse Average

Data period (months) 120 164 113