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Simon Gervais Spring 2010 – Term 1 In this case, you have to use data from comparables to estimate the cost of capital at Ameritrade. The process involves a few stages that this handout will guide you through. First, we need to determine which set of ﬁrms to use as comparable ﬁrms. You should try two diﬀerent sets. The ﬁrst set will include three discount brokerage ﬁrms: Charles Schwab Corp, Quick & Reilly Group, and Waterhouse Investor Services.1 The second set will include six investment services ﬁrms: A G Edwards, Bear Sterns, Merrill Lynch, Morgan Stanley Dean Witter, Paine Webber, and Raymond James Financial. Stock price and return data for these nine ﬁrms are provided in a separate spreadsheet that you can download from the course schedule at www.duke.edu/∼sgervais. In fact, this spreadsheet contains all six exhibits contained in the case. To estimate the equity beta for each of these ﬁrms, you will need to perform a regression of their past returns on past market returns (only the slope of this regression is useful for your analysis, i.e., there is no need to calculate/report on anything else). For this purpose, let us use monthly data from January 1992 through December 1996, that is, ﬁve years of monthly data as is the norm in practice.2 As you will see in Exhibit 5, the data for the discount brokerage ﬁrms includes stock price, dividend and stock split data. You will have to calculate monthly returns using this data. To help with the calculation of monthly returns, note that the return Rt of a stock in a given month t is Pt −Pt−1 +Dt if there is no stock split Pt−1 Rt = x x y Pt −Pt−1 + y Dt if there is an x for y stock split, Pt−1

where Pt denotes the stock price at the end of month t, and Dt denotes the dividend paid in month t. Exhibit 6 reports the monthly returns on the six investment services ﬁrms’ stocks, which you can use directly. The same exhibit also reports monthly returns on the value-weighted index of all U.S. publicly traded ﬁrms (on the NYSE, AMEX, and Nasdaq), which you should use as the market portfolio in your analysis. Once you have estimated the equity beta for all nine comparable ﬁrms, calculate the asset beta for each ﬁrm. In your calculations, assume that the corporate tax rate is zero, an assumption that we will revisit later in the course. Given that your regressions use data from 1992 through 1996, use the “Avg 1992-1996” debt-to-value ratios reported in Exhibit 4 for your calculations (use the market values ratios, of course). Finally, your will need a debt beta for all nine ﬁrms. Since debt betas are not provided in the case, assume initially that the debt beta is zero for all nine ﬁrms. Then redo your analysis using a debt beta of 0.25 for all nine ﬁrms. The last step of the process involves the estimation of Ameritrade’s cost of capital, i.e., the hurdle rate that it should use for its projects. From the case, it looks like Ameritrade uses little or

E*Trade has recently gone public and there is not enough data available to use it as a comparable at this point. As you will see, the data for Waterhouse Investor Services ends in September 1996. For this one ﬁrm, use only the 57 data points from 1992-96, as this should be enough.

2 1

1

• Why is the asset beta of discount brokerage ﬁrms larger than the beta of investment services ﬁrms? • Which set of comparable ﬁrms (discount brokerage or investment services) is more appropriate for Ameritrade to use and why? • For the market portfolio. i. including your monthly return calculations for the three discount brokerage ﬁrms.20%. In fact. why is it more appropriate to use the value-weighted index of all U.. The ﬁrst page of your report should be an executive summary similar to that on the last page of this handout. Government bonds. for your cost of capital calculations.no debt for ﬁnancing its projects. 1/3 each for the ﬁrst set. the rest of your report should include more details about your work (i. is 6. That is. let us assume that it will remain all-equity ﬁnanced for the foreseeable future. let us use the yield on long-term U. such a page is included in the spreadsheet that contains the data.00 and 0. Please make sure that this is presented in legible fashion so that your report can be graded eﬃciently and accurately.. • The risk premium on the market portfolio.e. • The riskfree rate. you can weigh the ﬁrms equally (i.25) to produce four estimates of Ameritrade’s cost of capital. rf . your spreadsheets). and 1/6 each for the second set).e. Use your two sets of comparables (discount brokerage ﬁrms and investment services ﬁrms) and your two assumptions about their debt beta (0. rm − rf . Also.. We will discuss how to estimate this number later in the course. On the second page of your report. is 7. Within each set of ﬁrms. feel free to use it.61%. you should provide brief answers to the following three questions. use the CAPM with the following assumptions. 2 .S.e. publicly traded ﬁrms as opposed to the equal-weighted index? Finally. Let us assume that it will keep ﬁnancing its operations without using debt.S.

00 0.Term 1 Individual Assignment #1 Last name: Gervais First name: Simon Section: 30A or 30B (for Fin251F).00 0.00 0.00 0.00 0.25) 0.00 0.00 Cost of Capital Estimates Based on Discount Brokerage Firms Investment Services Firms Assuming βD=0.00 0. 302 or 303 (for Fin351) Cost of Capital at Ameritrade: Executive Summary Market Data r m .00 0.00 Asset Beta (βD=0. 301.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 Asset Beta (βD=0.00 0.25) 0.61% Firm Charles Schwab Quick & Reilly Waterhouse Equal-Weight Average Discount Brokerage Firms Debt / Value Equity Beta (Market Value) 0.0 0.0) 0.0% 0.0% Assuming βD=0.20% rf = 6.00 Firm A G Edwards Bear Sterns Merrill Lynch Morgan Stanley Dean Witter Paine Webber Raymond James Financial Equal-Weight Average Investment Services Firms Debt / Value Equity Beta (Market Value) 0.0) 0.25 0.00 Asset Beta (βD=0.00 0.00 Asset Beta (βD=0.00 0.00 0.00 0.00 0.00 0.00 0.0% 0.rf = 7.00 0.00 0.00 0.0% .00 0.00 0.00 0.00 0.FINANCE 251F/351 Spring 2010 .00 0.00 0.00 0.00 0.

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