Ameritrade Case Study

What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why?

Ameritrade should consider: Net Present Value (NPV) of the investment in technology and advertising as well as the Internal Rate of Return (IRR) and Opportunity Cost of Capital. These measurements will take into consideration assumptions about project risks and market return which will help to determine if the investment in technology and advertising will reap as great a return as if the stockholders were paid out the value of the anticipated investment and invested it on their own elsewhere.

How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real (not financial) investment decision?

CAPM uses risk-free rate of return, market risk premium (the rate above the historical risk-free rate that will attract investors to a risky investment) and the investment's beta (relative risk of an investment compared to other risky assets). Based on the inputs into the formula, it would not matter what the investment is under consideration. The CAPM takes the premium over the risk-free rate that would entice someone to invest in something else and multiples that by the specific risk associated with the potential investment/project. The product of these two amounts is then added to the estimated future risk-free rate. The total equals the potential return on an investment or project.

Regardless of what is being invested, the formula helps to determine if the potential return is greater than the "safe" risk-free return.

What is the risk-free rate that should be used in calculating the cost of capital using the CAPM? Explain.

The risk-free rate should match the project horizon of the potential investment. The Ameritrade case mentions near-term investments are being considered, including enhancements in technology and a two-year advertising budget. The case also mentions that Ameritrade has a "long tradition of adopting the latest advances in technology."

Due to the two-year advertising budget proposal and Ameritrade's practice of investing in the latest technology (which would not have a prolonged useful life), the time horizon to determine the cost of capital for these investments is closer to five years. Therefore, the risk-free rate should reflect the anticipated five-year bond yield of 6.22%. The 10-, 20- or 30-year bonds are too long based on how rapidly things develop in the technology field, and the 3-month and 1-year bonds are not long enough to reflect the length of the investment (which will be at least two years based on the advertising budget being considered).

What is the estimate of risk-premium on the market that should be used in the CAPM? Explain.

The estimated risk premium to be used in the CAPM should be the excess of the market portfolio return over the historical risk-free interest rate. During the time period that this potential investment was being considered, Ameritrade had a market cap well over $1B, which categorizes the company as a large-cap company. Therefore, the comparable market portfolio for investing in Ameritrade would be the large-cap or large company stocks using 1950 - 1996 data (using data back to 1929 would not provide a good reference as there would not have been comparable companies in the market portfolio during that time period). Based on Exhibit 3, the market portfolio for this market would be 14.0%. After deducting the historical risk-free rate of 6.40%, based on the intermediate bond market rate also found in Exhibit 3, the risk premium would be 7.6%.

Ameritrade does not have a beta estimate as the firm has been publicly traded only for a short period at the time of the case. Exhibit 4 provides various choices of comparable firms. Which firms do you recommend as the appropriate benchmark for evaluating the risk of Ameritrade's planned advertising and technology investments? Explain.

Analysis of Exhibit 1 provides insight into Ameritrade's scope of business. For the three years that data is provided, nearly 90% of Ameritrade's net revenues were brokerage revenues consisting of transaction income and net interest. Looking to Exhibit 4 for comparable firms, we see that Charles Schwab Corp, E*Trade, Quick & Reilly Group, and Waterhouse Investor Services have similar portions of their business attributable to brokerage revenues. We therefore assume that these firms have similar business risks and can be used as an appropriate benchmark for evaluating the risk of Ameritrade's proposed project.

Additionally, these firms all represent other discount brokerage firms. Ameritrade is not a full blown technology or internet firm because they are only involved in a niche market of the internet so comparing them to Yahoo or Netscape would not make sense as those companies provide much broader technology and internet services than Ameritrade. Comparing Ameritrade to full-service brokerage and investment firms also does not make sense because Ameritrade does not offer the same level of service and therefore does not charge the same amount in fees as those other firms. While Ameritrade may be ahead of the curve on providing technology and internet access for trading options, those attributes provide a competitive advantage over other comparable firms in the discount brokerage business which should be used as comparable firms.

Using the data in Exhibits 3, 4, 5, and 6 calculate the asset betas for comparable firms.

Charles Schwab Corp, E*Trade, Quick & Reilly Group, and Waterhouse Investor Services were previously determined to be Ameritrade's comparable firms. Due to limited data for E*Trade, we will only be using Charles Schwab Corp, Quick & Reilly Group, and Waterhouse Investor Services in our calculations.

The asset betas for these firms can be found by using the following equation, which essentially unlevers the equity beta:

Asset = E * E/(D+E)

The equity betas, E, for the comparable firms are found by performing a regression calculation on the returns of each of the three stocks against the value weighted market index over a five year period. Returns were computed using data from Exhibit 5 and the following equation:

Return= (〖(Stock Split Ratio)*P〗_(t+1)-P_t+〖(Stock