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1.

What factors should Ameritrade consider when evaluating the proposed


advertising program and technology upgrades?

Ameritrade needs a cost of capital to evaluate new projects. Firms maximize their value by
taking all positive NPV projects.



i
i
i
r
CF E
NPV
*
1
... , 2 , 1 , 0 i

i
CF E is the expected cash flow in period i

*
r is the discount rate

If Ameritrade analysts use a discount rate that is too high, good projects may be
rejected. If they use a discount rate that is too low, bad projects may be accepted.

Also the Ameritrade analysts should consider, that their companys internal discount
rate was often used as 15%, but some managers felt appropriate the rate of 8-9%. At
this time, the external discount rate, used by Credit Swiss First Boston was 12%.

So actually computing the NPV earlier, Ameritrade analysts accepted only the best projects
which fitted their high requirements. Now at the end of our analysis, we see that
Ameritrade has a cost of capital close to 19.5%.

Therefore, we can't say for certain whether we will accept the project. We will need the team
to actually re-evaluate the profitability, the cash flow from the project and discount all using
this 19.5% rate to find the NPV, then we can have a solid conclusion.


2. What is the estimate of the risk-free rate
F
R that should be used in calculating
the cost of capital for Ameritrade?


In our opinion, we should use the risk-free rate equal to yield of 20-year US government
securities, because it is long-term capital investment. We may use 30-year rate, but we are
investing in technology, and concerning the speed of technological enhancements, 20-year
rate is optimal. So it is 5.50%.

3. What is the estimate of the market risk premium,
F M
R R , that should be used
in calculating the cost of capital for Ameritrade?

Historic Rf on LTB 5.50%
From exhibit 3c taking return value on portfolio of US Government bonds with matuarity near 20 years
this Rf is used to calculate the risk premium on govt. stocks in past.

Rm (Large company stock) 12.70%
From exhibit 3c taking average annual return on S&P's 500 stock price index

Premium (Rm-Rf) 7.20%
Estimated risk premium based on historic average returns on US Government Securities and Common Stock. From exhibit 3c.
4. Exhibit 4 provides various choices of comparable firms. Which firms do you
recommend as the appropriate benchmarks for evaluating the risk of
Ameritrades planned advertising and technology investments?

Let us agree that Charles Schwab is a comparable firm. Their price changes,
dividends, and stock split information for 1992-1996 is in Exhibit 5. If there were no
stock split, the return, compared to the previous period, is given by:

1
1

t
t t t
t
P
D P P
R . For example, if the price the previous period was $100, then went
up to $104, and in addition had a dividend of $8, the return would be +0.12, or 12%.
In a short time period, the returns will be much closer to 0.
If there is an x for y stock split, use the formula:

1
1

t
t t t
t
P
D
y
x
P P
y
x
R . To make calculating this efficient, we can set x and y equal to
1 for those periods when there is not a stock split, then we can just use the second
formula.