Ameritrade Case

Introduction

Ameritrade is considering price-cutting, technology enhancement, and increased advertising strategies in order to grow its revenue through self-directed investors. Ameritrade intends to reduce commissions from $29.95 to $8.00 per trade for all Internet market orders, allocate $100 million for technology enhancements, and increase its advertising budget to $155 million for the 1998 and 1999 fiscal years. Ameritrade needs to calculate the cost of capital for the project in order to determine if the project would generate sufficient cash flows to merit the investment.

Factors of Cost of Capital

The term “cost of capital” refers to the opportunity cost of the funds employed as the result of an investment decision or the rate of return that a business could earn if it chose another investment with equivalent risk. In essence, for a particular project to have a positive net present value (NPV), the return of the project must exceed that of an equally risky security. Ameritrade must evaluate interest rates, market risk premiums, business risk, financial risk, and the amount of financing available for the investment in order to determine the cost of capital. The importance of cost of capital is twofold: first, it sets a benchmark that a particular project must exceed in order to be rational; second, it provides a means of discounting cash flows in future periods in order to estimate the present value of the project, even if the cash flows occur over a period of multiple years. Since the objective of Ameritrade is to maximize shareholder’s value, having an accurate cost of capital would ensure a fair evaluation of the project.

Choosing Comparable Firms

As Ameritrade has a short trading history, the equity beta will be most accurately determined using those of comparable companies. Charles Schwab, E*TRADE, Quick and Reilly Group, and Waterhouse Investor Services are four similar firms in the discount brokerage industry that have analogous percentage of brokerage revenues as Ameritrade (Exhibit 4). E*TRADE is omitted from the pool of comparable firms since it does not have a sufficiently long history of trading for consideration.

Estimating CAPM Beta

To calculate the return of the three comparable firms, we used the following formula:

r_i=((x/y)(p_t+d_t )-p_(t-1))/p_(t-1)

We chose to compute the returns of the firms over the period of January 1992 to December 1996 in order to keep the time period consistent with the data found in Exhibit 4. We correlated the market index return using both the value-weighted and equal-weighted NYSE, AMEX, & Nasdaq figures for the period between January 1992 and December 1996 (Exhibit 6) according to the formula as shown to obtain the CAPM beta in the following table