Ameritrade Holding Corp. is a deep-discount brokerage firm, and the management of the firm is currently planning to make large investments in the marketing and technological developments in the firm. The reason behind the thought is to improve the company’s performance and competitive position by taking advantages of the possible economies of scale.
In order to analyze the strategic options available to the firm, the management needs to evaluate the abilities of these investments to generate positive future cash flows for the company. Currently, the CEO of the company uses a cost of capital of 15% to analyze the projects, however the company’s management believes the cost to be around 8-9% and the research analysts suggest it to be around 12%.
The major problem faced by the company is the disagreements on the cost of capital to be used in project appraisals for the company. Therefore, the management needs to decide a cost of capital to be used in project appraisal
Factors to be considered by Management
The management of the company should perform a cost-benefit analysis and the risk analysis, comparing the costs of investment in the technological and advertising upgrades to the returns generated by these projects.It should also consider the impact of price reduction on the cash flows from these projects. It can be believed that all the three intentions, including technological advancements, increased advertising and significant price cuts, are closely related to each other and should be analyzed in association with each other. The management of the company should establish an appropriate discount rate for the projects to avoid discrepancies in the NPV calculation and to anticipate the expectations of returns from the investors.
Estimates of Risk Free Rate and MRP
When deciding about the risk free rate to be used, it is considered that the projects are for the long term in future therefore, long term and current rates should be used. Hence, it is estimated that the risk free rate is the rate for 20 year government securities, which is 6.69%.
To consider a broader market, an average of large and small company stocks is taken for the risk premium. Therefore, the Rm is estimated to be 15.2% ((12.7+17.7)/2) and the market risk premium is calculated to be 15.2%-6.69% = 8.51%.
Steps for Computation of Asset Beta in CAPM
The asset beta is the weighted average beta of debt and equity, and in order to calculate that, it can be assumed that the debt is not related to the market risk of a company, leaving behind just equity. The asset beta is then calculated by un-leveraging the beta equity of the company by removing the effect of financial risk of the company. The formula used in calculating the asset beta is Beta Asset = Beta Equity * (Equity/ Debt + Equity).
Appropriate Comparable Firms
Charles Schwab, Quick and Reilly, and Waterhouse are recommended as appropriate benchmarks for evaluating the risks of Ameritrade, as these are the discount brokers and they also derive majority of their revenues from brokerage and their business model is comparably similar to Ameritrade.
Asset Betas of Comparable Firms
The asset betas of the comparable firms are calculated by making regressions of the monthly returns of these companies, compared to the market returns of NYSE, AMEX and NASDAQ. The current market Debt/Value ratios provided in the Exhibits are then used to un-lever these betas. The calculations are given in the Appendix.
Recommendations to the CEO
By averaging the Asset Betas of the comparable companies, and re-leveraging it with the debt to equity ratio of Ameritrade, a cost of equity of 22% is calculated. Since the financial statements of the company do not contain any long term debt, it can be assumed that the cost of equity of the company is its WACC.
By the information provided in the case, it can be seen that there are differing views regarding the type of business and discount rate for Ameritrade and so there can be different types of investors too. Therefore, it is recommended that the CEO takes into account multiple scenarios regarding the cost of capital and only accepts the projects that generate returns better than its cost of capital…………………
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