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Analysis of Cost of Capital at Ameritrade

Analysis of Cost of Capital at Ameritrade

Executive Summary

The CEO of Ameritrade, Joe Ricketts, is looking to invest a whopping US$ 155,000,000 increasing the marketing budget and US$ 100,000,000 in technology enhancements. As such, he must justify this investment by proving that the investment is worthwhile. In order to evaluate the investment Ricketts would like to use the NPV of the project in order to merit the investment; Ricketts needs to know the risk of the project.

The assumptions for our calculations can be found in Appendix 1 of this paper but the major one was deciding to compare Ameritrade to Charles Schwab as they are similar firms for reasons detailed later in the paper. We used the CAPM to find the costs and then the WACC to find the cost of capital.

We found a WACC (risk of the project) of 17.61% - higher than the discount rate often used by the CFO of Ameritrade.

Ricketts should use 17.61% to discount the future cash flows from his investments.

Introduction

Ameritrade is one of the first deep discount brokerage firms, founded in 1971. The firm makes the majority of its profits from the interest it charges customers for trades and not from commission fees charged for services. In 1997, the CEO of Ameritrade, Joe Ricketts, wanted to improve the company’s position; this required Ameritrade to grow its customer base. Ricketts planned on achieving this growth by investing in technological advancements (US$ 100m) and increasing the company’s advertising budget (US$ 155m). In order to decide whether the investment is worthwhile for Ameritrade, Ricketts needed to estimate the risk/reward of the project. In our paper we will estimate the cost of capital; or in other words, the risk that Ameritrade will take by comparing it to similar companies. All our assumptions will be stated during the paper and in the appendixes. Whenever making an investment in a project a factor of consideration is the NPV of the project. In order to calculate the NPV of a project we need the projected cash flows and the cost of capital (the WACC).

In order to obtain the cash flows we will need to have some kind of growth to apply to previous year’s

performance. In our case the CEO, Joe Ricketts, believed that the proposed investment would yield a very high reward “on the order of 30% to 50%”. However, other members of management were more conservative “estimating the expected investment returns at only 10% to 15%”. In our paper we will focus in solely on the cost of capital at Ameritrade.

In order to calculate a relevant cost of capital we will need to compare Ameritrade’s past performance to the

market. As Ameritrade has, at this point, only been traded for 3 months we will use financial information from

similar companies for our calculations. We are given a range of costs by reliable sources: a CS First Boston analyst used 12%, the CFO at Ameritrade often used 15% and some managers at Ameritrade used 8-9%. We will use the data available to calculate the cost of capital.

The CAPM

Initially we must assume that the CAPM, although a theoretical model, holds in order to use it. We will use the model to calculate the cost of equity and cost of debt for Ameritrade (Cost of capital). As Ameritrade has only been public for about six months, finding the costs will come via historical financial information from firms similar to Ameritrade. After we have calculated the cost of equity and debt we can use a weighted average (using Ameritrade’s financial information) to find the WACC. Now that we have the WACC we can use it in order to discount the projected cash flows and thus calculate the NPV of the project.

Computing the beta of equity through comparison with similar Companies The CAPM model takes into consideration the risk of the specific stock in relation to the market ( ) as part of

the calculation of the cost of capital and debt. In order to compute the beta we will need to run a regression, on the returns of each stock (our independent variable Y) and the return of the market (our dependent variable X). We will estimate a line that will be the best linear unbiased estimator fitted line. The slope (the coefficient) is the beta; it will represent the return on equity compared with the market return. Since Ameritrade is a new company in the stock market, we will use a similar company to estimate Ameritrade’s beta for equity. (Exhibit 2 Excel)

Which companies should we compare Ameritrade to?

Ameritrade is different from regular brokerage firms since they do not supply services relating to the stock

(such as asset management fees) rather they supply services relating to the trade itself. Ameritrade’s two primary sources of revenue were from transaction and net interest”. Ameritrade needs a vast number of trades in order to sustain itself. Charles Schwab is comparable to Ameritrade for two reasons: they are both discount brokerages and their brokerage revenues are similar (Ameritrade 90%, Charles Schwab 82%). Additionally, Charles Schwab is noted as being a competitor to Ameritrade.

Computing the Risk Free

We will need to find the risk free rate of the market. Using only the data given we will look in exhibit 3 on page

6 and find that the annualized yield of a 30 year US government bond is 6.61%. Therefore, the estimate that we will use for the risk-free rate is 6.61% = 0.0661. We take into consideration that the time horizon of Ameritrade project is for the long run. This is based on the assumption that as the majority of the investment is in marketing the aim of the investment is to increase the customer base that in turn will increase the core revenues of Ameritrade. When recruiting a customer the objective is to have him investing in the long run. For instance, if a customer aged 30 is recruited we expect him to invest and trade until his retirement (age ~60); if a new customer (age 30) arrives next year then the cash flows are for 31 years. Therefore, we used the longest available risk free rate.

Computing the Market Premium

The market premium is the reward that we get for bearing the systematic risk; its equation is

R

m

r

f

. As we

have already found a viable estimate for the current risk free rate we need a comparable historical risk free rate for the past in the market. In exhibit 3 on page 6 is the average annual return for large company stocks12.7%, we chose this number to be the Market risk as this reflects the fluctuation of the market as large companies carry more weight. Consistently with that we chose our Rf to be 5.5% the average annual return for long term bonds (the best comparable risk free rate to 30-year bonds) between 1929 and 1996. We chose this information in order to receive the best statistical average (longest period). Therefore, the market risk is 7.2% The market risk premium is equal to the market return less the risk free:

Market risk premium 0.127 0.055 0.072 7.2%

This will be the return we are expecting to receive above market return for our investment.

Computing the Beta of equity

As shown in Exhibit 1 (Excel) we ran a regression for Charles Schwab’s return on the market return the slope (Beta) we found is 1.577. This beta is the levered beta (beta with debt in its capital structure). We need to unlevered this beta in order to make it more applicable to Ameritrade situation (using our comparable company

capital structure). The unlevered beta is

E

1

D

E

* 1

1.5281

(Exhibit 1)

Computing the tax

According to the income statement the tax payable is 7,602,964 and the income before tax is 21,425,113.

Therefore, the tax rate is

7,602,964

 

21,425,113

0.354

35.4%

Computing the RE = R f + b E (R M R f ):

R

E

0.06611.528*(0.127 0.055) 0.1761 17.61%

Computing the RD= R f + b d (R M R f ):

As we have assumed the interest bearing debt to be zero in this case computing the cost of debt is a moot point. However, for examples sake the method for the cost of debt’s computation is as follows. At this point we would use the yield to maturity of the company’s bonds to determine the cost of debt. Alternatively, we can use the CAPM model to find the cost of debt; we will need first to find the Beta of debt. Usually (according to imperial data) this Beta is said to be zero. However, we will use 0.25 as our Beta of debt, as we are assuming that there is a certain risk. The cost of debt will be:

With a certain risk (β = 0.25)

Rd 0.06610.25*(0.127 0.055) 8.41% Rd 0.06610.00*(0.127 0.055) 6.61%

Without a certain risk (β = 0.00)

Calculating the WACC of Ameritrade

After that we determined the comparable company and the assumptions that within the WACC we proceeded to calculate the WACC of Ameritrade using the following formula:

D E   Market Market value value of of Equity Interest = Bearing Shares * Debt price   0 14,518*18.813 (See assumption 273,127.13 in appendix1)

V Total Assets 273127.130 273,127.13

D

V

0

E

V

1

WACC

D

*

V

R

D

*(1 )

E

V

* R

E

WACC 1*0.17610 0.1761 17.61%

This is the final cost of capital for Ameritrade that we calculated using our estimations. Calculations are given in Exhibits1&2 (Excel) WACC = 17.61%

Appendix 1

We used figures from the 1997 balance sheet of Ameritrade for the debt (D), equity (E) and value (E) in the formula:

WACC

D

*

V

R

D

*(1 )

E

V

* R

E

(All the calculations of the WACC were made in Exhibit 2 -excel.)

We assume that the CAPM holds. For the CAPM Rf+Beta*(Rm-rf), we assumed the first risk free rate was the current rate (Dec 1997) of 6.61%. The Rf inside the parentheses is the historical average annual return for long term bonds (the best comparable risk free rate to 30-year bonds) 12.7% and is consistent with the RM which is the average annual return for large company stocks (as this reflects the fluctuation of the market as large companies carry more weight) 5.5%.

We will use the data given to us in the “Cost of Capital at Ameritrade” case regarding the return on stocks of the

companies compared with Ameritrade to estimate the beta of equity by using the information of the stock return and equal weighted return including dividends of Charles Schwab and the market respectively.

When looking at the income statement we notice that no information is given regarding interest expense (only net interest as a positive flow). Therefore, we assume that Ameritrade has no interest bearing debt.

When calculating a suitable beta for Ameritrade we decided to calculate the unlevered beta of Charles Schwab. Due to the fact that Ameritrade has no interest bearing debt (calculations Exhibit 1 Excel)