Essay Ameritrade Cost of Capital

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Ameritrade is formed in 1971, and is a pioneer in the deep-discount brokerage sector.
In march 1997, Ameritrade raised $22.5 million in an initial public offering. Management at Ameritrade is considering substantial investments in technology and advertising, but is unsure of the appropriate cost of capital.

Estimating the cost of capital 1. Since we do not have the beta for Ameritrade, we need to find comparable firms for which we could compute the betas. There are several candidates in the case. Discuss which firms are most appropriate.

Thus, the proportion of the revenue a firm earns from transactions and interest (brokerage activities) has something to do with the risk. Thus, to find the firms of comparable risks, we may take
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CAPM = rf + B x (rm –rf)

4. What is the estimate for the risk free rate that should be employed in calculating the cost of capital for Ameritrade?
Since the project involves substantial investments in technology and advertising and the cash flows are projected in the future we can assume that it’s a long term investment so we should use long term rates and we should use current rates, not historical rates.
I’ll use a 10 year time horizon so the current 10 year interest rate is: 6.34%

5. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade?
The market risk premium for Ameritrade we should use the difference between the returns on small stocks (Ameritrade has a market capitalisation as of August 29, 1997 of $273,127,000 and the returns on long term (20 years) government bonds:
We use the more recent historical data as the first one includes war periods and is less modern and therefore less consistent with new technology.
Risk premium (1950-1996) = 17.8% – 6.0% = 11.8%

6. What do we use for Beta?
To compute betas we need the periodic returns of comparable companies and the returns of the value weighted market index as a whole. We regress both returns and get the slope of the line which is our Beta. We should use estimates for the last 5 years.




7. What comparable firms can
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