Essay about Cost of Capital at Ameritrade

1002 Words Mar 26th, 2013 5 Pages
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
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Interest revenues were generated by charging customers on debt balances maintained in brokerage accounts and the investment of customers’ cash segregated in compliance with federal regulations in short- term marketable securities. Interest revenues were offset by interest payments to customers based on credit balances maintained in brokerage accounts.
Virtually all of Ameritrade’s revenues were directly linked to the stock market. Investors generally curtailed trading activity and their borrowing in response to sustained downward movements in the stock market. For example, trading activity declined more than 20% in 1988 following the stock market crash of October 19, 1987. A substantial decline in the stock market could therefore lead to a steep decline in Ameritrade’s brokerage commissions and net interest revenues.
Full-service brokers were less sensitive to market movements than deep-discount brokers like Ameritrade. Full-service brokers received asset management fees, which partially shielded the revenue stream from market declines. Moreover, most full-service brokerage firms such as Merrill Lynch diversified their revenue stream by engaging in investment banking activities such as mergers and security underwritings.
Planned Investments and the Cost of Capital
Ricketts planned to grow Ameritrade’s revenues by

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