Questions Covered

1. What factors should Ameritrade management consider when evaluating

the proposed advertising program and technology upgrades? Why?
2. How can the Capital Asset Pricing Model be used to estimate the cost
of capital for a real (not financial) investment decision?
3. What is the estimate of the risk-free rate that should be employed
in calculating the cost of capital for Ameritrade?
4. What is the estimate of the market risk premium that should be
employed in calculating the cost of capital at Ameritrade?
5. In principle, what are the steps for computing the asset beta in the
CAPM for the purposes of calculating the cost of capital for a project?
6. Ameritrade does not have a beta estimate because the firm has been
publicly traded for only a short time period. Exhibit 4 provides various
choices of comparable firms. What comparable firms do you
recommend as the appropriate benchmarks for evaluating the risk of
Ameritrades planned advertising and technology investments?
7. Using the stock price and returns data in Exhibits 4 and 5, and the
capital structure information in Exhibit 3, calculate the asset betas for
the comparable firms.
8. How should Joe Ricketts, the CEO of Ameritrade, view the cost of
capital you have calculated?


Dear Andy! Sorry for my second delay with the case it is all the preparation to
universityexams. I shall try to finish Friendly Cards in time.So I used to make parallels
from cases to our real life and economic situation in Ukraine. At thetime we do not
have such companies as Ameritrade in Ukraine, because this kind of businessdoes not
have its customers right now. This is a new thing to our country, and as usual, all
thenew things are taken distrustfully.I can recall only one example : it is FOREX, but it
actually deals with the currency exchangerates, buying and selling currency. The only
same thing all the processes are being held online.

1 . Wh a t f a c t o r s s h o u l d A me r i t r a d e c o n s i d e r wh e n e v a l u a t i n g
t h e p r o p o s e d a d v e r t i s i n g program and technology upgrades?Ameritrade
needs a cost of capital to evaluate new projects. Firms maximize their value by taking
all positive NPV projects.
( )
( )

+=
iii
r CF E NPV
*
1

...,2,1,0
=
i
( )
i
CF E
is the expected cash flow in period
i
*
r

is the discount rateTo calculate an NPV, we need a discount rate. In the A-Rod case we
used 8%. In theOcean Carriers case we used 9%. In this case we will learn how to
determine anappropriate rate.If Ameritrade analysts use a discount rate that is too high,
good projects may be rejected.If they use a discount rate that is too low, bad projects
may be accepted.Also the Ameritrade analysts should consider, that their companys
internal discount ratewas often used as 15%, but some managers felt appropriate the
rate of 8-9%. At this time,the external discount rate, used by Credit Swiss First Boston
was 12%.
Goodobservation.
So actually computing the NPV earlier, Ameritrade analysts accepted only the
best projects which fitted their high requirements.
Now at the end of your analysis, we seethat Ameritrade has a cost of capital close to 22%. This
high hurdle rate means thatAmeritrade should only accept projects with a very high potential
rate of return (aslong as they are of similar risk levels).
2 . Ho w c a n t h e Ca p i t a l A s s e t P r i c i n g Mo d e l ( CA P M) b e u s e d
t o e s t i ma t e t h e c o s t o f c a p i t a l for a real investment decision? (Note: A
real
investment decision here is contrastedfrom a
financial
investment decision. We are talking about real projects, with investmentin people and
technologies, etc.)

Because we are talking about risks, we should think about systematic and versatile
non-systematic?
risks. Systematic risks usually depend on overall economical situation,government
steps, state economic policy and law base risks. In the US this kind of risk
iscomparatively low. But in Ukraine it will be much higher because of unstable
economy,government policy and laws. That is why computed cost of capital would be
higher, if this company was situated in Ukraine.
That seems reasonable to me.
Ameritrades cost of capital should reflect a
risk premium
to account for the uncertaintyof the expected future cash flows in addition to reflecting
the time value of money.Cost of capital =
+=
F
Rr
*
risk premium
F
R
is the risk-free return, reflecting the time value of money. Textbook materialexplaining
the CAPM is available on my website. The figure below may help tosummarize:The
CAPM provides a useful framework for determining the discount rate by definingthe
risk premium
above. The diagram illustrates expected return for a stock,
S
R
. Wewant the expected return (the appropriate discount rate) for investments in various
assets,which are financed by a combination of equity and debt, so we use the subscript
A
in place of
S.
In slope-intercept form, the expected return, or appropriate discount rate, may be given
as:
( )
F M Ameritrade A F
R R Rr
+=

*
AmeritradeA

is called beta of the assets of Ameritrade, and represents the risk of Ameritrade. A
company of average risk gets a beta of 1.0.

R
is the return of the average-risk company, or equivalently, the return of a broad- based
portfolio of companies, like those listed on the New York Stock
Exchange(NYSE).3 . W h a t i s t h e e s t i m a t e o f t h e r i s k -
f r e e r a t e
F
R
that should be used in calculating the costof capital for Ameritrade?Since the projects
being contemplated are long-term projects, we should use long-termrates. Since the
projects are in the future, we should use current (at the time of the case)yields, not
historical rates.In my opinion, we should use the risk-free rate equal to yield of 20-year
US governmentsecurities, because it is long-term capital investment. We may use 30-
year rate, but weare investing in technology, and concerning the speed of technological
enhancements, 20-year rate is optimal. So it is 6,69%.
Sounds reasonable to me.

4 . W h a t i s t h e e s t i m a t e o f t h e m a r k e t
r i s k p r e m i u m ,
F M
R R

, that should be used incalculating the cost of capital for Ameritrade?Typically analysts
use the stock market return minus U.S. government bond returns.Unlike the bond
market, where the current yields are the unbiased market prices for bonds whose cash
flows are in the future, we dont have a reliable estimate of where thestock market will
move in the future. Stock brokers have a conflict of interest; if they areoptimistic, and
can persuade people of their optimism, then more funds should flow intothe stock
market and their commissions and salaries increase. Thus we typically usehistorical
spreads over a long period of time, covering many business cycles, and suggestthat
with no better information, we anticipate the future to be like the past. Also, largestocks
tend to better estimate the market than small stocks. That is why we may use
the difference between US Government Securities rate (6,69%)and historical Large
Company Stocks annual returns. But we have 2 numbers: during1950-96 and 1929-96.
The difference between them is 1,3%. I think that we should useyounger value of 14%,
because the years 1930-1949, of course, were under marketeconomy, but at the same
time there were not so stable laws, a Second World War passed, many companies at
that time worked for government orders, so this number may be a bit out of overall
tendencies.
I appreciate your thoughtfulness. You are quiteperceptive. The opposite side of this argument is
that we dont know what thefuture will bring. Perhaps we will have another period of world war,
or terribleglobal market conditions. If such a scenario is not unreasonable, then
we shouldntexclude past data that relates to such times.

F M
R R

=14%-6,69%=7,31%.

5 . I n p r i n c i p l e , wh a t a r e t h e s t e p s f o r c o mp u t i n g t h e a s s e t
b e t a i n t h e CA P M?


A cost of capital is a weighted average of the cost of debt and equity. Likewise, the
asset beta is the weighted average betas of debt and equity. We use
market value
proportionsof debt and equity (see CAPM, p. 476).
E D A
E D E E D D

+++=
It is common to assume that debt has no relationship to market risk; that
.0
=
D

Empirical studies of corporate debt returns suggest it would be better to assign
some
market-related risk to corporate debt; and use estimates ranging from 0.20 to
0.30. Wewill compute both.To get
E

, the equity beta for Ameritrade, we would
normally
run a regression of equityreturns on stock market returns. That is, we would estimate
the slope of the line that bestfits:
Unfortunately, Ameritrade had their IPO (Initial Purchase Offer) in March of 1997,
sothere is not enough data at the time of the case to calculate a reliable beta
estimate. Soinstead, we will look at comparable firms. Firms in the same industry
pursuing the sametypes of projects will have the same sorts of risks, thus their
asset betas
will beapproximately the same. The returns we calculate for these firms, based on stock
pricemovement, dividends, and stock splits, are their
equity betas.
These are influenced by thedegree of leverage each company is using (recall that
higher leverage leads to higher ROE, EPS and DPS, but also leads to greater
variability in earnings). Knowing theamount of debt in their capital structures (at market
values), we can calculate the asset beta for each comparable firm. Then we will
average these to use as a proxy for Ameritrades asset beta.Please see spreadsheet
work.
This is very good. I would just make two observations,however: 1) the debt to total capital ratios
in Exhibit 4 are for the period 1992-1996.


Therefore you should only use equity returns from the same period. 2) The returnfor the very
first period is not a useful number, because you are implicitlysubtracting 0 as the previous price
of the stock.

6 . E x h i b i t 4 p r o v i d e s v a r i o u s c h o i c e s o f c o mp a r a b l e
f i r ms . Wh i c h f i r ms d o y o u r e c o mme n d as the appropriate benchmarks
for evaluating the risk of Ameritrades planned advertisingand technology
investments? Determine the betas for these firms.Let us agree that Charles Schwab is
a comparable firm. Their price changes, dividends,and stock split information for 1992-
1996 is in Exhibit 5. If there were no stock split, thereturn, compared to the previous
period, is given by:
11

+=
t t t t t
P D P P R
. For example, if the price the previous period was $100, then wentup to $104, and in
addition had a dividend of $8, the return would be +0.12, or 12%. In ashort time period,
the returns will be much closer to 0.If there is an
x
for
y
stock split, use the formula:
11

+=
t t t t t
P D y x P P y x R
. To make calculating this efficient, we can set
x
and
y
equal to1 for those periods when there is not a stock split, then we can just use the
secondformula. Here are the first few rows for Schwab

Copy the Rt values into Exhibit 6 alongside the appropriate dates, then regress
theSchwab returns against the value-weighted NYSE returns for the same period. The
slopeof the line is the equity beta.Do this for the other comparable firms. Calculate the
asset betas using the formula inquestion 5 (twice, once with
0
=
D

and once with
25.0
=
D

). Average the results.This should be a good estimate of Ameritrades
asset beta. Finally, put these results back into the equation in #2 to estimate
Ameritrades cost of capital.Please see spreadsheet
calculations.7 . W h a t v a l u e ( s ) f o r
*
r
did you come up with? DONE!!r* for debt beta = 0 is 20,1%r* for debt beta = 0,25 is
20,4%.

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