Ameritrade case Essay

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Ameritrade!

David Cao

Jane Xuejing Li

Mike Xu

Dongye Zhang

KNOWLEDGE FOR ACTION

Background!
• Ameritrade was a deep-discount brokerage firm that planned to invest heavily in technology and advertising to increase customer base and brand awareness! • Needed an estimation of the risk of the investment to evaluate whether the strategy would generate sufficient future cash flows!
• Average ROE during 1975 to 1996 was 40% (except for two years). The most recent five years posted returns larger than 40%. !
• Deep-discount brokers such as Ameritrade are more sensitive to stock market fluctuations than full-service brokers!

KNOWLEDGE FOR ACTION

Question 1: What factors should Ameritrade management consider when evaluating the expansion proposal? Why? 

!• Unclear cash flow and revenue

Budget for technology enhancement and marke=ng should increase accordingly with the growth of revenue.

• Labor cost occurred during expansion needs to take into account.

•

•

High ROE • Ameritrade has a 91% debt ra=o • Creditors would ask for a higher risk premium

•

Debt cost of capital • If there is a significant risk that the firm will default, the yield to maturity of the firm’s debt will overstate investors’ expected return.

•

Equity Cost of Capital • Underes=ma=ng cost of capital would result in overes=ma=ng future return

•

Stock market

• Decline in stock market would lead to decreased trading ac=vi=es and borrowing by investors, which would reduce Ameritrade’s revenue and its ability to pay debts

KNOWLEDGE FOR ACTION

Question 2: How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for a real investment (as opposed to a financial investment)? 
 • ! Unlike a financial investment, a real investment normally has no historical data for es=ma=ng market risk premium

•

Iden=fy a comparable firm

•
•

•

Find a comparable firm in the same line of business as the new project Es=mate the cost of capital of the assets of comparable firms and then use that es=mate as a proxy for the project’s cost of capital

All-­‐equity financed firm vs unlevered firm •
•

All-­‐equity: use the comparable firm’s equity beta and cost of capital as es=mates for beta and the cost of capital of the project. Unlevered:

• the firm’s leverage makes the equity riskier and the beta not a good es=mate of the beta of its assets and of the project • Recreate a claim on the firm’s assets by holding both its debt and equity simultaneously and calculate the beta of the firm’s asset (it matches the beta of this porTolio)

KNOWLEDGE FOR ACTION

Question 3A: Using the CAPM- What is your estimate of the riskfree rate to use for the cost of capital for Ameritrade? Why?

!Exhibit 3 from case: Capital Market Return
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