Ameritrade Holding Corporation

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Case Background

Ameritrade Holding Corporation (AMTD) is a deep-discount brokerage firm that has recently completed an IPO. Management at Ameritrade is considering substantial investments in technology and adverting to exploit emerging economies of scale, but is unsure of the appropriate cost of capital.

Questions:

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

When it comes to evaluate the proposed advertising and technology program, Ameritrade management generally needs to consider the return of this investment and the underlying possible risks. Return is the main factor management should consider, because management’s objective is to maximize the firm value.  Knowing the risk of the project will give the management more precision in evaluating the project. When measuring the return or risk of the project, management needs to predict the amount of cash flows generated in each period, the discount rate and the time to invest this project. Management also needs to predict how much risk Ameritrade can tolerate and consider the ways that can cover the risks. Moreover, the management should pay attention to the market trend and its competitors. For example, will technology upgrades become the trend of discount brokerage business? Are technology upgrades widely used by its main competitors? Are technology upgrades welcome by its current customers? Or can the project enhance competition strengths, such as attract the potential customers? In addition, management needs to consider the comments from employees about this project.

In conclusion, the factors Ameritrade management consider when evaluating the proposed advertising program and technology upgrades include risk and return of the project, cash flow generated, time of the investment, risk tolerance, risk coverage, market trends, competition, and the employees’ views.

2. CAPM Estimate

The CAPM has two risk free rates and the expected return on the market:

1. What is the appropriate market index?

The appropriate market index is value weighted market index. CAPM requires to use value weighted market index, because value weighted market index calculates the weighted average of the returns on each security and the weights are proportional to outstanding market value.

Equally weighted index weights each stock equally regardless the weight of each stock.

RM = 14.0%. 

Compared to the data from 1929 to 1996, the data from 1950 to 1996 is more recent, so we choose data from 1950 to 1996. According to Exhibit 3, Historic Average Total Annual Return on U.S. Government Securities and Common Stocks (1950-1996), the average annual return for large company stocks is 14%. Ameritrade is a large company, so we choose 14% as RM.

2) What is the appropriate risk free-rate for the risk premium? RF?