...analysis "Cost of Capital at Ameritrade" Cost of capital refers to the maximum rate of return a company must earn from its investments, so that the market values of the company’s equity shares do not go down. The people at Ameritrade are not in agreement on the best estimate of the cost of capital. Research analyst put the cost of capital at 12%, while other members of the management estimate it to be at 9% and the CFO estimates it to be at 15%. The CEO of the company is optimistic that the rate of return is greater than the cost of investments. However, it will be difficult to continue with the project without agreeing on the estimate of the cost of capital. Determining the company’s cost of capital is essential for both capital budgeting and capital structured planning decision. Cost of capital can be classified as either implicit cost or explicit cost. Implicit cost is the rate of return associated with forgone opportunities attributed to investments on other projects. Explicit cost is the discount rate that equates to the present value the funds that the company receives from net underwriting costs. In order for the company to determine the average cost of capital, it is essential to consider the cost of each method of financing. This will be useful for the company since the profitability of the project will be judged on the basis of the cost of the sources for financing the project. This provides a composite cost of capital which is inclusive of all the costs of capital...
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...FIN 5439 – Capital Structure and Risk Management Nimlendran Guidelines for the “Cost of Capital at Ameritrade” Case This is a group assignment: * Each group will provide answers to the questions given below Note: You do NOT have to provide a full case report * Submit only one report per team. Submit a word document on Canvas course site. * The report should be well formatted and using 12 point font. Double spaced. All the tables should have their headings and all the units (% , million etc.) clearly indicated. A Word document should be submitted on the course website by one team member before the deadline: All calculations and estimates using Excel should be in formatted tables and inserted directly into the Word document. Note: From the Excel output, only include the important estimates and relevant statistics such as t-stats and standard errors. GRADIN RUBRIC Grade Item | Points out of 100 | Presentation including grammar and style, tables, follow instructions) | 20 | Q1 | 10 | Q2 | 10 | Q3 | 10 | Q4 | 20 | Q6 | 30 | Learning Objectives The case provides an opportunity to understand how capital market data and asset pricing model(s) can be used to estimate the cost of capital (or the required rate of return) for real investments. You do NOT have to write a formal report, but you should provide concise answers with all the assumptions stated clearly for the questions given below. * Estimate stock returns from prices by adjusting...
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...201-046 Cost of Capital at Ameritrade Exhibit 1 Consolidated Annual Income Statements for the Fiscal Year Ending in September 1997 Net Revenues Transaction Income Net Interest Other Total Net Revenues Expenses Excluding Interest Employee Compensation Commissions and Clearance Communications Occupancy and Equipment Cost Advertising and Promotion Provision for Losses Amortization of Goodwill Other Total Expenses Excluding Interest Income Before Income Taxes Taxes Net Income EPS Shares Outstanding Source: Ameritrade Annual Report, 1997. $ $ 51.936.902,00 $ 18.193.946 7.107.492 77.238.340 1996 36.469.561,00 $ 11.477.878 6.391.314 54.338.753 1995 23.977.481,00 8.434.584 2.607.538 35.019.603 19.290.808 3.320.262 5.623.468 5.422.839 13.970.834 59.000 363.002 7.763.014 55.813.227 21.425.113 7.602.964 13.822.149 $ $1,00 13.768.889 14.049.642 2.530.642 3.685.535 2.889.654 7.537.265 148.014 363.002 4.717.406 35.921.160 18.417.593 7.259.248 11.158.345 $ $0,87 12.813.823 8.481.977 2.516.796 2.352.590 1.626.725 4.842.392 1.428.663 94.152 2.846.280 24.189.575 10.830.028 3.798.881 7.031.147 $0,55 12.813.823 t Ameritrade Cost of Capital at Ameritrade 201-046 Exhibit 2 Consolidated Annual Balance Sheets for the Fiscal Year Ending in September 1997 1996 ASSETS Cash & Gash Equivalents Cash & Investments Segregated in Compliance with Federal Regulations Receivable from Brokers, Dealers, & Clearing Organizations Receivable from Customers & Correspondents Furniture...
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...Cost of Capital at Ameritrade: 1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? When deciding whether or not to invest in the proposed advertising program and technology upgrades, Ameritrade should consider the following four key factors: 1. Cost of Capital: It is important that Ameritrade understand the risk associated with this project’s cost of capital. Ameritrade should look at the cost of capital to determine if the expected return on this project will be equal to or greater than investing this capital elsewhere. 2. Net present value of the cash flow: After looking at the cost of capital, Ameritrade will want to look at the cash flows for the project and determine the net present value of the cash flows. This will help Ameritrade understand if this is where they want to invest their money, but understanding how much they will receive annually from this project. 3. Accurate discount rate: Ameritrade will want to know if this project can deliver more than the discount rate. It is important to choose an accurate discount rate since an overstatement or understatement could lead to the wrong investment decision because of using an incorrect benchmark. 4. Debt to Equity ratio: Ameritrade should look at their debt to equity ratio compared to other companies in their industry. Since Ameritrade could potentially compare against two different industries, they will want to...
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...Ameritrade Case 1. 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 order, allocate $100 million for technology enhancements, and increase advertising budget to $155 million for two fiscal years (1998 to 1999). Ameritrade is considering whether to implement the project because it is unsure about the cost capital of the project. 2. The 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 the Ameritrade case, the cost of the advertising program and the investment in the physical plant and technology and its price strategy could be a potential risk to Ameritrade. Having an accurate cost of capital would allow the evaluation of the risk of the investment, thereby ensuring the maximization of the shareholder value in the company. Cost of capital can be separated into two parts: controllable and uncontrollable factors. Ameritrade can control its capital structure (either more debt or more equity), dividend (payout ratio), and investment policy to manage its cost of capital. Uncontrollable factors include level of interest rates and tax rates. * General Economic Conditions * Affect interest...
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...do not have such companies as Ameritrade in Ukraine, because this kind of business does not have it’s customers right now. This is a new thing to our country, and as usual, all the new things are taken distrustfully. I can recall only one example : it is FOREX, but it actually deals with the currency exchange rates, buying and selling currency. The only same thing – all the processes are being held online. 1. What factors should Ameritrade consider when evaluating the proposed advertising program and technology upgrades? Ameritrade needs a cost of capital to evaluate new projects. Firms maximize their value by taking all positive NPV projects. [pic] [pic] [pic] is the expected cash flow in period i [pic] is the discount rate To calculate an NPV, we need a discount rate. In the A-Rod case we used 8%. In the Ocean Carriers case we used 9%. In this case we will learn how to determine an appropriate 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 company’s internal discount rate was 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%. Good observation. So actually computing the NPV earlier, Ameritrade analysts accepted only the best...
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...1. What factors should Ameritrade’s management team consider when evaluating the proposed advertising program and technology upgrades? How significant are these factors from a risk perspective? Based on the case, we know the company Ameritrade Holding Corporation is a deep-discount brokerage, and the company’s proposed strategy is to increase the customer base by being a low-cost provider against its competitors. The company plans to invest more towards technology and advertising, and cut costs to improve the firm’s service, capacity, and customer awareness. If Ameritrade should go forward with this investment, it’s prudent to consider some factors. From a risk perspective the company should calculate the cost of capital as a basis for project evaluation. Ameritrade should also calculate the net present value (NPV) to determine the costs and benefits of the proposed investments. When calculating the NPV we should be aware of choosing the appropriate discount rate, which is the most important factor in the formula. Using too high or too low a discount rate can increase the uncertainty of future cash flows. Lastly, the company should also consider cash flows when evaluating the investment. If a company wants to start a new project or investment, cash will be the biggest determining factor. The CEO Joe Ricketts strongly believed his company can do this investment, however, his management team does not have enough confidence that they can get the higher expected return. Thus, at...
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...Cost of Capital at Ameritrade 1) Briefly describe the project that Ameritrade is considering In order to maintain its competitive edge in the discount brokerage market, Ameritrade is considering making major investment state of the art technology that can prevent system outages and guarantee 100% reliability. The new system would enable Ameritrade to follow its mission of becoming the largest brokerage firm based on the number of trades. As part of the project the firm would also invest in a new marketing campaign to promote its improved services and capabilities. The company would invest $100 million in the technology enhancements and $155 million in marketing during 1998-99 (up from $14 million in 1997). To increase the trade volume, the company is also considering reducing commissions for all internet market orders by more than 70%. 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? Cost of capital is the cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. The Cost of Capital is important as the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively...
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...Corporate Finance Case Study Solution 1. What factors should Ameritrade consider when evaluating the proposed advertising program and technology upgrades? Ameritrade needs a cost of capital to evaluate new projects. Firms maximize their value by taking all positive NPV projects. is the expected cash flow in period i is the discount rate To calculate an NPV, we need a discount rate. In the A-Rod case we used 8%. In the Ocean Carriers case we used 9%. In this case we will learn how to determine an appropriate 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 company’s internal discount rate was 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%. Good observation. 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 see that Ameritrade has a cost of capital close to 22%. This high hurdle rate means that Ameritrade should only accept projects with a very high potential rate of return (as long as they are of similar risk levels). 2. How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for a real investment decision? (Note: A real investment decision here is contrasted...
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...Ameritrade – case study Executive Summary Ameritrade provides online brokerage services and operates an Internet-based financial management services business. 90% of the company’s revenues are from the provision of discount brokerage services. The company’s objective is to improve its competitive position in deep-discount brokerage. In order to achieve this objective, the company must grow its customer base, requiring an investment of $100 million to upgrade its technological capabilities as well as an increase of $155 million for its advertisement budget. In order to evaluate the company’s cost of capital, we used the Cost Asset Pricing Model. Since the company went public recently, it would not be an accurate assessment of the risk of the investment to find the beta of this short time period. Therefore, we chose a similar company called Charles Schwab, which has very similar sources of revenue, discount brokerage services. However, this company has a very different capital structure, so we unleveraged the beta in order to get the best, most accurate beta for Ameritrade. We assumed that the capital structure of Ameritrade did not have debt, and that the project would be financed with equity only. We found a levered beta for Charles Schwab of 2.15. After unlevering it, we got a beta of 1.8768. When using the CAPM model, we concluded that the cost of capital of Ameritrade is equal to 20.40%. Factors to be considered in evaluating the project Various factors must...
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...Cost of Capital at Ameritrade 1 Objective j • This case provides the opportunity for you to p estimate the cost of capital. • To develop an understanding of how capital market data and the CAPM can be used to estimate the required rate of return for real investments 2 Background g • Ameritrade: formed in 1971, IPO in March , pioneer in the deep-discount p 1997, a p brokerage sector. – Helped create the deep discount market – The first to offer many new services that changed th way i di id l i h d the individual investors managed t d their portfolios. 3 • Ameritrade’s strategy: to grow its customer , q base, which required substantial investments in technology and advertising. • Needed an estimate of the project’s risk. risk 4 Q Question • How risky are these cash flows? • How are they related to the stock market? 5 To-do’s • Determining what firms can be considered comparable when estimating the cost of capital • Calculating returns from stock prices g q y • Estimating CAPM equity and asset betas from capital market data g g • Understanding the effect of leverage on equity betas g pp p • Evaluating how appropriate the estimated cost of capital is for different types of real investments 6 The Discount Brokerage Business g • What are the primary sources of revenue? – Transaction revenues • Brokerage commissions • Clearing fees • Payment for order flow – Interest revenues • Margin lending to customers • Interest on investment of...
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...Cost of Capital at Ameritrade 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 for Ameritrade? 5. In principle, what are the steps for computing the asset beta in the CAPM for purposes of calculating the cost of capital for a project? 6. Ameritrade does not have a beta estimate as 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 Ameritrade’s 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 estimate you have calculated? Colorscope, Inc. 1. Why would any customer, let alone large advertising agencies and departmental stores, go to Colorscope rather than go to the large printers listed in Exhibit 3? ...
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...Ameritrade 1) What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? Ameritrade management should consider both the NPV and the project’s cost of capital when evaluating the proposed advertising program and technology upgrades. This will help to compare the expected return on investment for the project with the project’s cost of capital. The expected return on investment should be more than the cost of capital in order for the project to be profitable. The management should also consider the project’s NPV. A larger expected future cash flow means larger NPV. The NPV should be assessed and the management should only accept the project if it is positive. The management should also be very careful with the degree of discount rate it applies. The project could be overvalued or undervalued if the discount rate is not appropriate. The management should only accept the project if the opportunity cost is more than the cost of capital and the NPV is positive. The management should also consider future cash flows as a lot of the company’s cash will be tied up in investment and is used as a financial strength indicator. So a high debt to equity ratio will mean that the company financed its growth with debt and that could lead to a lot of loss ultimately. The management should also be aware about how the swings in market will affect the expected return on investment. Ameritrade could also find itself in trouble...
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...cost of capitalHarvard Business School 9-201-046 Rev. April 26, 2001 Cost of Capital at Ameritrade In mid-1997, Joe Ricketts, Chairman and CEO of Ameritrade Holding Corporation, wanted to improve his company’s competitive position in deep-discount brokerage1 by taking advantage of emerging economies of scale. The success of the strategy required Ameritrade grow its customer base. The growth would require substantial investments in technology to improve service and capacity, and in advertising, to increase customer awareness. The strategy would require large expenditures relative to Ameritrade’s existing capital. In order to evaluate whether the strategy would generate sufficient future cash flows to merit the investment, Ricketts needed an estimate of the project’s risk. Company Background Formed in 1971, Ameritrade has been a pioneer in the deep-discount brokerage sector. Not only did Ameritrade help create the deep discount market, but it also was the first to offer many new services that changed the way individual investors managed their portfolios. Ameritrade, for example, was the first to offer automated touch-tone phone trading (1988), online internet trading2 (1994), a personal digital assistant to access trades (1995), and online program investing for individual investors (1996). The average return on equity during 1975 to 1996 was 40%, as all years, except two, posted a positive return. Recent returns on equity were much higher, with each of...
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...Ameritrade Case Analysis Question #1: Ameritrade is planning on spending $155M in the next two fiscal years on advertising and $100M on technology upgrades. Management would need to consider if this large capital investment would directly result in future cash flows large enough to offset these investments at a rate that would satisfy the debt owners and shareholders. Management would need to determine the rate of return for these investments and compare this to the cost of capital, calculated using betas from comparable companies to determine accurate relationships to market fluctuations. If the rate of return for the project is less than the cost of capital, management can conclude that the investment would be more wisely spent on other projects. Additionally, they would need to determine the time required for the investments to effectively result in future cash flows through calculating the IRR. Since Ameritrade revenues are strongly influenced with downturns or upturns in the market, it would be advisable for them to analyze future market trends to determine whether this investment would yield positive results. Calculating Ameritrade’s beta would allow them to determine how at risk they are to trends in the market. Question #2: The CAPM states that an investor’s expected rate of return equals the risk free rate plus the market risk premium weighted by beta. Since managers are expected to make decisions that add to shareholder value, projects that do not provide a return...
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