Case: Cost of Capital at Ameritrade
Ameritrade is formed in 1971, and is a pioneer in the deep-discount brokerage sector.
[A deep-discount broker is a broker that offers lower commissions than a discount broker, but also provides fewer services to clients. Such a broker usually will not provide anything beyond execution of stock and option trades, and will charge a flat fee regardless of the size of the trade]
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.
Since the firm has been publicly traded for only a short time…show more content… However, if there is a significant structural change, more recent data may give better estimate of the risk premium. We are not sure which one is better. So let us use both cases. Risk premium (1950-1996)=14.0% – 6.0%=8% Risk Premium (1929-1996)=12.7% – 5.5%=7.2%
4. Compute equity & asset betas for comparable firms Exhibit 5 shows the stock prices for the comparable firms. The return is computed as Return = (Pt+1 – Pt + Divt+1)/Pt As can be seen, there have been some incidences of stock split. 3 for 2 means that 2 shares are split into 3 shares. Next slide shows how to adjust to the stock split.
4. Compute equity & asset betas for comparable firms (Contd)
If the y shares of stock is split for x shares (x for y), we adjust the return using the following formula. x x Pt 1 Pt Divt 1 y y Re turn Pt
Now, using the Value Weighted NYSE index as the proxy for the market return, compute equity betas for each company. Use the past 5 years of data to compute the beta. After computing equity beta, using the Debt-value ratio in Exhibit 4, unlever the equity beta, (i.e., compute the asset beta from equity beta).
5&6 Compute asset beta for the Ameritrade and compute the cost of capital Estimate the asset beta for the Ameritrade The compute the cost of capital for Ameritrade. The estimated cost of capital should be around 20%. Relatively high cost of capital reflect the fact that most of the revenue is highly sensitive