Fin 325 - Cost of Capital at Ameritrade

FIN 325 CASE #1: COST OF CAPITAL AT AMERITRADE

Group 21

Pau Ching Hin

Phung Tan Hai Long

GT Lee

Carson Schneider

1. Briefly describe the project that Ameritrade is considering.

In order to continue its tradition of adopting the state of the art technology and to increase its market share in deep-discount brokerage market, Ameritrade is considering a project that will help its revenue growth by targeting self-directed investors. To do so, Ameritrade plans to initiate a project that aims to cut commissions from $29.95 to $8.00 per trade, enhance trade execution speed with up to $100M budget, and increase advertising with an increased budget of $155M.  It is crucial to obtain an estimate of Ameritrade’s cost of capital in order to determine whether they should proceed with the project or not.  

2. The title suggests that the cost of capital is important here. Concisely describe what cost of capital means. It is the cost of what to whom? Why is it important? What factors determine the cost of capital?

At large, cost of capital represents the cost that Ameritrade undertakes when financing its businesses. In essence, cost of capital is the return that an investor gives up on an alternative project that is equally risky. One way of raising the capital is by issuing debt or equity, and the firm owes investors the return equal or better. Whether Ameritrade decides to invest in aforementioned project largely depends on the cost of capital, where the firm will proceed with the project if and only if it is less than the expected return on planned investment. Cost of capital depends on Ameritrade’s historical returns to investors, Ameritrade’s capital structure, and the risk premium that investors demand.

3. Ameritrade has a short history of trading, so its equity beta cannot be computed precisely using its own historical data. Exhibit 4 provides some choices for comparable firms. Which of these firms do you think are appropriate to use as comparables to determine the beta of Ameritrade’s planned advertising and technology investments?  Why?

In order to estimate the beta of Ameritrade’s investments in advertising and technology, three discount brokerage firms, Charles Schwab, Quick & Reilly and Waterhouse Investor Services are used as comparables^[1]. Given that Ameritrade’s core business lies in the deep-discount brokerage sector, analyzing financial data obtained from intra-industry companies would be reasonable, as these firms bear similar types and levels of risk in operations as Ameritrade’s.  Hence, the data from these three discount brokerage firms can be used to gauge the magnitude of risk of investment and market sensitivity of Ameritrade’s assets, as opposed to investment service firms with diversified operations or Internet companies, which may not be suitable to be used as comparables in this case.