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MGT 6060 Financial Management Summer 2011

Prof. Jonathan Clarke

Case 3: cost of Capital at Ameritrade

Group Members: Kristin Fadeley Venkata Kuppusamy Benedikt Schroeder Yogesh Vasisht Manoj Vattakkunnel

Question 1: What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? In a nutshell, Ameritrade's management should do a cost-benefit analysis, comparing proposed investments into technology upgrades and advertising with the Net Present Value of the expected incremental free cash flows ("FCF's") that those two projects would add to the company's currently expected FCF's. On the investment, or capital expenditure side, Ameritrade should carefully consider any estimates of time and money with regards to the envisioned technology upgrades: Ameritrade is not just planning on increasing capacity, which might be as simple as an investment in additional bandwidth and hardware (servers), but also service improvements, which are likely software upgrades that are notorious for running over time and over budget. Management should therefore run multiple scenarios based on potential cost and time overrun scenarios to assess under which circumstances the project stays NPV positive. Advertising campaigns are less likely to cause surprises on the investment side since they can be limited to a certain budget, but their success is very hard to predict. Even if the agency that Ameritrade ultimately selects can more or less precisely determine, how many potential new customers will be exposed to Ameritrade's new campaign, based on ratings, subscriptions and frequency of print and broadcast, it can only ever be a guess how many people will actually start using Ameritrade. That brings us to the revenue side of this NPV calculation: Ameritrade will have to anticipate how much additional revenue-generating brokerage business the technology enhancements, capacity increases, and advertising campaign will add to its top line, and how fixed and variable costs will react to calculate the actual incremental cash flows. Again, Management should use best and worst case scenarios based on the impact of prior advertising and technology enhancements, and benchmarks from other companies to calculate potential outcomes. It should also account for the risk of various future market conditions, since the business is sensitive to the direction of the market. The case describes that various members of management expected returns between 10 and 50% which shows that the expectations varied widely. At the same time as the roll out of these two investments, Ameritrade is also planning a significant price cut for its single-trade brokerage fees. The interesting next question is, how would that affect the revenues and cash flows and should all additional revenues from this three-prong strategy (tech enhancement, advertising, & price cut) be included in the NPV calculation? We suspect that the three are tightly linked, with the advertising necessary to announce the better service and lower prices to the consumers, and the technology enhancement needed to handle the expected increase in order volume and frequency, that all three should be viewed together and the effects included in the calculation. However, if volume does not increase and reduced trading fees only lead to a massive reduction in revenue, the strategy might even have negative incremental cash flow. Finally, Ameritrade's management needs to establish the discount rate for the NPV calculation. Since DCF's can be rather sensitive to the discount rate, especially when

calculated over a longer period of time, small differences in the rate can have a big impact on the assessment of the project. The discount rate is important since the company will need to obtain money for these investments from investors, either debt or equity. These investors will have certain return expectations that need to be met to hand their money to Ameritrade and management needs to anticipate these expectations and have a plausible story to meet or exceed them, before they will pull their check books. Question 2: Ameritrade does not have a beta estimate as the firm has been publicly traded for only a short time period. What comparable firms do you recommend as the appropriate benchmarks for evaluating the risk of Ameritrades planned advertising and technology investments. We propose using an average of the unlevered betas of comparable companies to come up with an unlevered beta for Ameritrade, assuming that investors will view Ameritrade similarly to other discount brokerage firms. Exhibit 4 shows a number of trades companies that have comparable business lines to Ameritrade's but we would focus on three of them to come up with an average beta: Charles Schwab, Quick & Reilly, and Waterhouse. We wouldn't just select them because they are marked as "Discount Brokerage", which is the business that Ameritrade is clearly in, but because they derive the majority of their revenues from Brokerage (81-99%). Ameritrade's income statement in Exhibit 1 shows that in 1997 67% of its revenues came from Transactions and 24% from Interest. We assume both sources should be viewed as revenues from brokerage since the interest income is not from an independent deposit or credit business but merely from the credit lines of brokerage accounts and the management of money sitting in these accounts. E*Trade is also a discount broker with 82$ revenue from brokerage, but we only have 12 months of stock data and the beta is somewhat off the chart (Exhibit 7), whereas the other 3 companies have reasonably comparable levered betas when you look at them over a long period of time (Exhibit 7 & 8) Other companies on the list have significantly lower brokerage revenues since they have other income sources such as management, origination and advisory fees from their financial management, book building, and M&A business (like Lehman or Morgan Stanley), or none at all. And while management may view Ameritrade as a tech company it doesn't seem to make sense to compare it to Yahoo or Google when there are much closer competitors with very similar business models. Question 3: Using the stock price and returns data in Exhibits 4 and 5, and the capital structure information in Exhibit 2, calculate an estimate of Ameritrades cost of capital For our calculations for an estimate of Ameritrades cost of capital, we have made following assumptions. We are using the 3 closest competitors for which we have sufficient historic data, Charles Schwab, Quick & Reilly, and Waterhouse per above to calculate an average beta.

We are calculating betas for those 3 companies based on regressions of their monthly returns (Exhibit 5) compared with the market returns in Exhibit 6, see Exhibit 7 & 8. We are using the equal weighted NYSE, AMEX and NASDAQ . We have calculated betas for multiple periods (Exhibit 7) and noticed that shorter periods deliver widely varying results. We are therefore calculating our betas on the longest period for which we have data for those stocks. We are using the current Market Debt/Value ratios from Exhibit 4 (except for Waterhouse, where we use the historic average since the data is not available) to unlever the betas, since investor look at the current situation and market valuations when making an investment decision. We interpreted the data to mean "Debt/(Equity)Value" for lack of better description of the columns B & C. Risk Free Rate rf From Exhibit 3 we are using the current annualized Yield to Maturity for 5-year US Government bonds as risk free rate since Ameritrade investment is in Technolgy and Advertizing. As both Technology and Advertizing have shorter shelf life and we don't expect direct returns from an Advertising and technology project lasting beyond few years, we are using 5-year Bond rate as risk free rate. Risk Free Rate for 5-Year Bonds is 6.22% (From Exhibit 3) Market Risk Premium (rm-rf) To determine Market Risk premium, we looked at both periods 1950-1996 and 1929-1996 and then decided to use the longest term available. The longest term encompasses various ups and down of the market from recession to booms as well as the low times World war and great depression. From Exhibit 3, we are using the spread between the 67-year average return on intermediate bonds (with maturity near 5 years) and the average of Small and Large Company Stocks for the risk premium: And we use an average of Small and Large Caps since we calculated the betas based on an overall Stock Market comparison, so feel we also need to use a broader market for the risk premium. From Exhibit 3, Historic Annual Returns (1929-1996), Average Annual return on intermediate bonds = 5.4% Average annual return on Large and small company stock = (12.7+17.7)/2= 15.2% Market Risk Premium = 15.2%-5.4%= 9.8% Cost of Equity: From Exhibit 4, the unlevered long term beta is Charles Schwab Corp 1.68 Quick & Reilly Group - 1.9 Waterhouse Investor Srvcs 1.08 Average Unlevered Beta = (1.68+1.9+1.09)/3 = 1.55 Therefore, The cost of Equity for Ameritrade is calculated as = risk free rate + beta * (Market rate - Risk Free rate)

= 6.22%+1.55*(15.2%-5.4%) =21.5% Based on Ameritrade's balance sheet in Exhibit 2 we are assuming that Ameritrade currently had no debt since all liabilities with exception of taxes are payables. So the WACC only contains an equity component and we are assuming that equity shareholders are going to be asked to fund the investments. Hence Cost of Capital= D/V (1-t)*rd +E/V*re Based on our assumption, D=0 and E=V Cost of Capital = Cost of Equity = 21.5%

Questions 4: How should Joe Ricketts, the CEO of Ameritrade, view the cost of capital estimate you have calculated? The calculated Cost of Capital estimate can only be one scenario in a range of possible calculations. The calculation will be a rational, theoretical calculation of the expectation of an educated and well informed analytical investor who uses the same assumptions as we did, and Joe Ricketts should treat it like that. However, as the case states there are differing opinions as to how Ameritrade should be values and what companies are comparable, so it is very likely that there are investors out there that will have very different expectations, and there will also be irrational investors who will look at Ameritrade as an Internet stock and who would buy equity in Ameritrade even if the it was doing nothing but burning cash right now with no clear plan how to make money. But there may also be more conservative investors who view Ameritrade for the same reason as a much more risky stock than its well established competitors that we used to calculate a beta and therefore expect higher returns. Therefore, Ricketts needs to run multiple scenarios and he may need to discount the recommendation on the margin if the resulting DCF shows a slightly negative NPV and he and his management team are convinced that this is the right path to grow and stay competitive.