Case 6: Cost of Capital at Ameritrade Summary: Formed in 1971, Ameritrade Holding Corporation has been a pioneer in the deepdiscount

brokerage sector, with its main sources of revenue being from transaction and net interest. Virtually all of Ameritrades revenues were directly linked to the stock market, so the state of it has a great effect on the companys brokerage commissions and net interest revenues. Full-service brokers were less sensitive to market movements than Ameritrade given that they received asset management fees, which partially shielded the revenue stream from market declines. Also, they engaged in investment banking activities such as mergers and security underwritings to diversify their revenue. In mid-1997, Joe Ricketts, Chairman and CEO, wanted to improve the competitive position of the company in this sector by taking advantage of emerging economies of scale. To do so, he wanted to implement a strategy that focuses on growing Ameritrades customer base by cutting prices, enhancing the technology, and increasing advertising. First, Ameritrade would have to reduce commissions from $29.95 to $8.00 per trade for all Internet market orders given that there were currently no major players in this price range although many customers were price sensitive. Also, Ricketts believed that state of the art technology was the sole way of preventing system outages and to move toward the goal of 100% reliability. Therefore, up to $100M would be budgeted for technology enhancements which also would increase trade execution speed - an important feature to individual investors. Finally, Ameritrades advertising budget would be increased by $155M for the 1998 and 1999 fiscal years combined. To gauge the financial impact of the advertising program and the investment in physical plant and technology required to carry out the strategy, there needed to be some accounting for the projects risk. Of course, the plan would only create value if the investment returned more than it cost. Because Ricketts believed that his role as CEO was to maximize shareholder value, if the expected returns on investment were greater than the cost of capital, he was going to invest, even if there was a chance of bankrupting the firm. He felt that the expected return on investment was very high, on the order of 30% to 50% while some members of his management team were not so optimistic given that they estimated the returns to be merely 10% to 15%. Recently, an analyst report employed a discount rate of 12% when evaluating the company. The CFO at Ameritrade often used a 15% discount rate while the managers there felt that the borrowing cost of 8-9% was the appropriate rate by which to discount the future profit estimates. To evaluated if sufficient future cash flows to merit this investment would be generated, Ricketts needed an estimate of the projects risk. A consultant was hired by the CEO of Ameritrade to provide a cost of capital estimate that could be used in evaluating the companys upcoming investments. Cost of Capital: Based on the following assumptions, we determined Ameritrades cost of capital to be 18.88%.

Capital Asset Pricing Model (CAPM) - This is a model that says that the expected return of a security or a portfolio is equivalent to the rate on the risk-free security plus a risk premium. If the expected returned does not meet or beat the required return, then the investment should not be made. It is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. So, the CAPM formula is ra = rrf + a (rm-rrf) where rrf = the rate of return for a risk-free security, rm = the broad markets expected rate of return, and a = the beta of the asset. Tax Rate This was calculated by using information from the income statement, Exhibit 1. We divided Taxes by Income Before Income Taxes: 7602964/21425113 = 35.49% for 1997. Calculating Beta - The slope of the graph between return on the stock (y axis) and return on the market (x axis). Risk-free Rate - Because this is a longstanding project, a long-term rate will be utilized. U.S. Treasury bills and bonds are most often used as the proxy for the risk-free rate. A majority of analysts attempt to match the duration of the bond with the projection horizon of an investment. For example, if using CAPM to estimate Stock As required rate of return over a 10-year time horizon, we would use the 10-year U.S. Treasury bond rate as our measure of rrf. Given that the data of the market is given in 14 years (1984-1997), and the three comparable companies are close to the range of ten years, we decided to choose the risk-free rate as the 10-year bond rate. Also, because this project is forward looking, we will use the current (1997) rate of 10-year bond of 6.34%. Risk Premium - Normally, the market rate can't be predicted since there are so many factors are involved, so historical data is used. Assuming that there isnt better information, the future will come about close to the past. And as the Etrade company was out of business within two years, we can see that risk is pretty high in this market. Because of that, we decided to use the 1929-1999 period market return in the calculation as this includes a wide range of business cycles, including the Great Depression to factor in the highest risk, all in order to not be overly optimistic regarding this project. Then, we also chose the Large cap company since these companies represent SP 500 better; Small cap stock is only SP 400, and Small cap tends to be more highly volatile than the Large cap, and given that the company is expecting to expand, to become a large player in the market, the Large cap return will be chosen. Therefore, the market return used will be 12.7%. This risk premium is historical risk premium, which is expected to be the same for the future. To calculate, we subtract the market return of 12.7% from 5.5%, which is the long-term bond average annual return historically. Please note that we want to use the historical 10-year bond return but as the footnote indicates, merely the 20-year bond return is available and as we want to be a bit conservative, this figure is appropriate to be used. Therefore, the risk premium is 7.2% Beta - We regress to find the slope of the three competitors data and the value weighted market return. Please note that we chose these three because they are in the same industry

of the discount brokerage and because Ameritrade just gone IPO, using comparables for its beta is appropriate. Equally weighted wont be used given that it will entail too much transaction costs and is not quite good assumption to use for all consumers. Then, after we find the betas of these 3 companies (which are levered beta), we unlever the betas using Hamada equations, with the assumptions that Ameritrade will not use debt and that its competitors will barely use debt to finance as well. Also, the fact that Ameritrade has quite good return from the equity for a firm that has not yet gone public, it is safe to assume that they will use the same practice in the future. For debt/equity value to use in Hamada equation, we convert it from the debt/value given in Exhibit 4. After we have all three betas, we simply take the average of the three as the beta to use for CAPM in order to calculate cost of capital for Ameritrade (and in this case it's the cost of equity only), which is 1.74. After plugging every piece into CAPM, we find the cost of capital being 18.88%.

Recommendation: Given that this is a quite higher discount rate to be used in the project than most of the estimations of the analysts, we will need to ensure that we will not be accepting a bad project nor reject a good one. The CEO himself is quite overly optimistic about the project since he expected return of over 30%, implying that we should adopt the project, However, his management team is more conservative with figure of only 10-15% implying that we should not adopt the project Therefore, we can't say for certain whether we will accept the project. We will need the team to actually re-evaluate the profitability, the cash flow from the project and discount all using this 18.88% rate to find the NPV, then we can have a solid conclusion