COST OF CAPITAL OF

AMERITRADE
 INTRODUCTION

Ameritrade is formed in 1971, and is a pioneer in

the deep-discount brokerage sector.
[A deep-discount broker is a broker that offers lower commissions than a discount
broker, but also provides fewer services to clients. Such a broker usually will not
provide anything beyond execution of stock and option trades, and will charge a flat fee
regardless of the size of the trade]
 In march 1997, Ameritrade raised $22.5 million in an initial
public offering. Management at Ameritrade is considering
substantial investments in technology and advertising, but
is unsure of the appropriate cost of capital.
 Viability Of Project

Estimation of Cost of Capital will help in evaluating

Ameritrade’s upcoming investments.

If,
Expected Return on Investment (30 – 50 % Given)
> Cost Of Capital

Project is viable.
 Estimating the cost of capital

 Cost of Capital is being calculated by following

steps :

1. Since data for Ameritrade is not given, Beta will be

calculated from the data of comparable firms.

2. Find the risk-free rate.

 Estimating the cost of capital (Contd)

3. Find the market-risk premium

4. Compute the equity betas for comparable firms. Then based on

the results, compute the beta for each firm.

5. Taking the average of the betas for the comparable firms, and
use this as the estimate for the beta for Ameritrade.

6. Use the estimated beta, compute the cost of capital.

 1. Deciding comparable firms

Considering the discount brokerage firms, Charles

Schwab, Quick & Reilly and Waterhouse Investor
Services appear to be the comparable firms.
 2. Find Risk Free rate

 To determine the risk free rate, match the economic life of the
project. Considering a significant investment in technology and
the goal of the company to be a large brokerage firm, the project
is considered to be of 5 years. Thus, we may use the prevailing
yield of 5-year bonds. (See Exhibit 3)

Risk Free rate= 6.22%

 3. Find the Market Risk Premium

 We use the difference between the historical large company

stocks and long term bonds.

 Market Risk Premium (1929-1996)=12.7% – 5.5%=7.2%

 4. Calculate betas for comparable firms

 Exhibit 5 shows the stock prices for the comparable firms. The
return is computed as

Return = (Pt – Pt-1 + Divt )/Pt-1

 If the y shares of stock is split for x shares (x for y), we

adjust the return using the following formula.
Return = ((x/y)Pt – Pt-1 + (x/y)Divt )/Pt-1
 Ameritrade

Cov(Kj , Km)
Beta =
Var(Km)

Company Equity beta

Charles Schwab 2.26
Quick & Reilly 2.17
Waterhouse 1.32
Ameritrade 1.92 (Average )
 Cost of equity using CAPM

Plug into security market line

 rf= 6.62%, rm – rf = 7.2%

 beta is 1.92

 Required Cost of Capital = 6.62% + 1.92(7.2%) = 20.1%

ri  rf   i (rm  rf )
 Calculate the WACC for Ameritrade

Assumptions:
Relatively risky young firm
Even with small debt, assume rd = 8.5%
Assume statutory tax rate of 35% is reasonable estimate

WACC formula:
D/(D+E) = 5%, by assumption, similar to Schwab
Rd = 8.5%
Tc = 35%
WACC = (.05)(8.5%)(1 - .35) + (.95)(20.1%) = 19.67%

 D   E 
WACC   rd (1  Tc )   reL
DE DE
 CONCLUSION

THE WEIGHTED AVERAGE COST OF CAPITAL FOR

THE PROJECT IS 19.67% WHICH IS LESS THAN THE
EXPECTED RATE OF RETURN. SO PROJECT IS
VIABLE
THANK YOU !!!

Apoorva Jain
Manisha Arora