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1.

Description
Ameritrade, in 1997, wanted to expand their customer base and improve their overall
competitive position in the deep-discount brokerage industry. In order to do so, their Chairman
and CEO, Joe Ricketts, wanted to invest in technology and, correspondingly, marketing in order
to attract more customers. Ameritrade wanted to position themselves apart from their
competition by drastically reducing commissions. In order to do this and remain profitable, they
will need to increase their client base.

3. Ameritrade has a short history of trading, so its equity beta cannot be computed precisely
using its own historical data. Exhibit 4 provides some choices for comparable firms. Which
of these firms do you think are appropriate to use as comparables to determine the beta of
Ameritrades planned advertising and technology investments?
Why?

What factors should Ameritrade Management consider when evaluating the proposed
advertising program and technology upgrades? Why?
When considering the proposed advertising program and technology upgrades, we have to
ensure that the project will likely add value to the company, so we need to consider the return
on investment versus the cost of capital. If the return on investment, measured by the net
present value and internal rate of return, exceeds the cost of capital, the investment should be
taken. In addition, we need to evaluate the projects systematic risk (beta), which includes risks
that are not unique to a particular project and not easily manageable by a project team at a
given point in time.

How can the C.A.P.M be used to estimate the cost of capital for a real (not financial)
investment decision?
C.A.P.M describes the relationship between risk and expected return of the investment. In order
to use the CAPM to estimate the cost of capital for this investment decision, we need to identify
comparable companies, extract their unlevered beta (since we dont have the information for
Ameritrade), determine the appropriate manner to average them, and apply the resulting beta
to the investments CAPM. We use an unlevered beta of comparable companies because every
company has a unique capital structure and leverage has no affect on the risk or return of a
firm's assets.

The CAPM is an important measure when it comes to real investment decisions because it
provides a basis of comparison for financial decisions. The return on a project must be greater
than what the firm can earn by investing an equivalent amount of money in financial
investments.
How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real
(not financial) investment decision? The CAPM states that an investors expected rate of return
equals the risk free rate plus the market risk premium weighted by beta. Managers are expected
to make decisions that add to shareholder value. If the project does not provide a return greater
than the investors expected rate of return, the project should not be undertaken. Additionally,
when you use unlevered beta (asset beta) you reflect on the project risk not the companys
financing risk.

1. What factors should Ameritrade management consider when evaluating the proposed
advertising program and technology upgrades? Why?
a. Opportunity Cost Will Ameritrade benefit from spending money on advertising and
technology upgrades more than the next best alternative and more than reinvesting the
money.
b. Debt-to-Equity Ratio If this ratio is high then Ameritrade may be able to generate more
equity and increase earnings by more than the cost then the shareholders will benefit
because more earnings will be spread amongst shareholders.
c. Future cash flows If futures cash flows are high and Ameritrade is able to remain cash
positive, and then they will have more protection against market volatility.
d. Return on Investment or Equity this will tell Ameritrade if the proposed upgrades and
additional advertising will generate earnings growth and by how much (additional money
for shareholders as well).

COST OF CAPITAL = OPPORTUNITY COST
HOW ? CAPM results can be compared to the expected rates of return that investor can possibly
earn in other investments with similar risks
Case analysis "Cost of Capital at Ameritrade"
Cost of capital refers to the maximum rate of return a company must earn from its investments,
so that the market values of the companys equity shares do not go down.

If we use historical average of total annual return of small CAP stocks as our market risk,
we also have to use historical risk-free rate do determine the risk premium. For the
CAPM method, the historical average return on market should never be used with the
current risk-free rate.
DATA: Historical Rf = 6.0% (Long Term Bonds b)
But current Rf is year bonds. So this approach has current Rf and then historical in
riskpremium.

We dont have reliable estimate where stock market will move in future. So we are using long
term historical spreadsheets for estimate & large stock than small stocks because they are more
closer to proper estimate of market
We are considering all values after Second World War because after that laws became stable in
U.S.
U.S. government securities rate = 6.69% (20 years bond, Exhibit 3)
Average annual return for Large company stocks = 14 % (Exhibit 3)
So Risk premium for Ameritrade
= 14 % - 6.69 % =7.31 %

The risk free rate that should be used when calculating the cost of capital, using the CAPM
would be 6.22%, because this is the 5-year bond annualized yield to maturity. The 5-year bond
give us an accurate look for use in the CAPM, because the technological venture that they are
about to go into need to be renewed continuously.
To determine the risk free rate, I would use to match the economic life of the project, counting
that yes is a significant investment in technology and the goal of the company to be the largest
brokerage firm, however technology needs to be renovated every couple of years, and
advertising too, the project in considering I Would take it as a short t term project. Thus, I would
use the prevailing yield of 5-year bonds from exhibit #3 where the Risk Free rate= 6.22%

Ameritrade should use a 6.10% risk free rate when calculating its cost of capital. This is the
average of the 20 year bond annualized yield to maturity (on August 31, 1997) and the long
term historical average annual return (from 1929 ? 1996). The long term bond return was used
because it provides an accurate average annual return since it reflects many years. The 20 year
bond as of August 31, 1997 was used because it is the current yield to maturity. They were
averaged in order to get a rate that would reflect current rates, but also be more reliable since it
involves data from many years.

What is the estimate of the risk-free rate and the market risk premium that should be employed in
calculating the cost of capital for Ameritrade?
From Exhibit 3,
The risk-free rate = 6.61% (30-year bonds)
The risk premium is equal to the annual return on common stocks reduces that on government
stocks.
The risk premium (1950-1996)= 14.0% (large company stocks)- 6% (the annual return on government
stocks)= 8%
The risk premium (1929-1996)= 12.7% (large company stocks)- 5.5% (the annual return on
government stocks)= 7.2%

What is the estimate of the risk-free rate that should be employed in calculating the cost of
capital for Ameritrade? Because Ameritrade is going to make a substantial investment in
technology and the objective of the company is to become the largest discount brokerage firm,
we are considering this to be a long term project. To match the economic life of the project, we
will use the prevailing yield of long term bonds. Yield to maturity of 30-Year Bonds is 6.61%