Essay Ameritrade Cost of Capital

Estimate the cost of capital for financing (Hint: Interest expense and total debt – Ascertain the return on equity to provide measures for the interest rate and the return to stockholders.

The cost of equity is the theoretical return that equity investors expect or receive from the company for investing their funds in the company. The risk free rate that is the Government Treasury bill rate is 3.1%, the market risk premium is 7% and the beta has been calculated as

The table below shows the equity betas for the firms presented in the case (using Jan-92 to Dec-96 equal weight NYSE/AMEX/NASDAQ as market portfolio):

We use the equation ri=(Pt-Pt-1+Dt)/Pt-1 to calculate the monthly return of stock of Charles Schwab Corp, Quick & Reilly Group and Waterhouse Investor Srvcs. Then we have two methods to calculate the Beta of Equity for each company.

As long-term valuation is assumed, risk free rate is set as 30-year treasury rate, 5.73%. Cost of debt is 6.72% reflecting Amoco’s credit level. Cost of equity is calculated as 10.63%, leading to final WACC at 8.85% (Chart 1).

35 4.2.1 Calculation of Risk Free rate ..................................................................................................... 35 4.2.2 Calculation of Average return .................................................................................................... 35 4.2.3 Calculation of Beta..................................................................................................................... 36 4.2.4 Calculation of Required Rate of Return ..................................................................................... 37 4.2.5 Calculation of

c. What is the highest five-year interest rate such that this project is still profitable?

Part II. For this exercise, it is assumed that the present yield to maturity of US government bonds is 4.5% (it is actually much lower). The market risk premium is assumed to be 6.5%. Using the capital asset pricing model, we can estimate the cost of equity for Constant Contact. The capital asset pricing model is a method of determining the value of a company based on current market characteristics and the historic performance of the company versus the broad market.

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

b. If the firm’s beta is 1.6, the risk free rate is 9% and the expected return on the market is 13%, what will be the firm’s cost of equity using the CAPM approach?

Using the stock price and returns data in Exhibits 4 and 5 (or, if you wish, other equivalent data sources), and the capital structure information in Exhibit 3, calculate the asset betas for the comparable firms. What is the appropriate estimation period to compile the data?

It equals: FCFF = EBIT (1- Tax Rate) + Depreciation - Capital expenditures - Increase in Net working capital. In this case, Kroger’s unlevered free cash flow in next five projected years are respectively 1424.2, 1438.0, 1479.7, 1526.9, and 1578.7 million (Appendix 8). Second, the weighted average cost of capital is calculated by the formula: WACC = Cost of Debt * (Debt value/Total value) * (1 – Tax Rate) + Cost of Equity * (Equity Value/Total Value). In this case, Cost of debt for Kroger is generated by using the weighted average interested rate of Kroger’s long-term debt (Table 9). Cost of debt = 4.5%. Cost of Equity is calculated by using CAPM method. Risk-free rate, market premium and beta used in this case is 2.95%, 5.0% and 0.7. Cost of Equity = 6.45%, and WACC = 5.52% (Appendix 7). The total net present value of net five year’s free cash flow is calculated as 6339.0 million.

1. What is the weighted average cost of capital for Marriot Corporation? Briefly outline the key assumptions that you made in computing the WACC. 2. What is the cost of capital for the lodging and restaurant divisions of Marriot Corporation? Briefly outline the key assumptions that you made in computing the cost of capital and outline any limitations that are presented by your analysis. 3. If Marriot uses a single company-wide cost of capital for evaluating investment opportunities in each of its line of business, what do you think will happen to the company over time? 4. Briefly describe how each of the following events will likely impact Marriot’s cost of capital: (a) An increase in the long-term T-Bond rate by 2%. (b) Increased

The equity beta given is 0.97, calculated for the period 1986 – 1987 using the stock returns. This beta gives us the risk attached to Marriott Corporation’s shares.

a. Based upon the cost of capital approach, what is the optimal debt ratio for your firm?