Ameritrade Case Solution

FIN 5439 – Capital Structure and Risk Management

GROUP 4

MINI – REPORT of CASE STUDY of AMERITRADE

TEAM MEMBERS:

1. Sanket Yagnik
2. Durgesh Sharma
3. Sudnyana Kadagadkai

1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why?
   → Ameritrade management should consider the following factors when evaluating the proposed advertising program and technology upgrades.

1. Sustainability of the project – How long can Ameritrade maintain a cost strategy before the project becomes obsolete? This will assist in calculating present value of the expected future cash flows.

PV = ∑ CF/(1+WACC)t

1. Cost of capital and future cash flows: These will assist in calculating the NPV of the project. Cost of Capital will help to determine if the investment in technology and advertising will reap as great return.
2. State of the economy: State of the economy plays an important role estimating the future cash flows of Ameritrade since the revenue of Ameritrade is tied to the stock market.
3. Risk Free Rate, Market Risk Premium and Beta: These will assist in calculating the expected return of the project. We can use the expected return to determine whether the project is acceptable or not.
4. Cost of Debt: The cost of raising debt has an impact on the WACC equation.

1. CAPM Estimate

            The CAPM has two risk free rates and the expected return on the market:

[pic 1]

a. What is the appropriate market index? (Value weighted, equally weighted, small cap, large cap, S&P etc.)[pic 2]

• Ameritrade is a small cap company. The no. of shares outstanding is 13,768,889. Assuming the stock price didn’t vary much in September, we get the market capitalization (assuming stock price = $18.813) equal to $259 million. From Exhibit 3, we get that the average annual return for the small cap company from 1950-1996 is 17.8%

b. What is the appropriate risk free-rate for the risk premium? [pic 3]

• Considering the life span of project to be of 10 years. Since the time horizon for the project is 10 years, we can take historical average return of Long Term Bonds which is 6%

c. What is the CAPM Risk free rate??[pic 4]

• The risk-free rate should match the project horizon of the potential investment. The time horizon to determine the cost of capital is closer to 10 years. Therefore, the risk-free rate should be 6.34% (Exhibit 3)

1. Ameritrade does not have a beta estimate as the firm has been publicly traded only for a short period at the time of the case. Exhibit 4 provides various choices of comparable firms. Which firms do you recommend as the appropriate benchmark for evaluating the risk of Ameritrade’s planned advertising and technology investments? Explain.

• Ameritrade had their IPO in the month of March 1997. Thus, there’s not much data available to calculate a reliable beta estimate. To estimate the beta we will look at comparable firms. Firms in the same industry pursuing same types of projects will have the same sorts of risks and thus their betas will be approximately same. Following are the comparable firms to estimate the beta:

1. Charles Schwab Corp
2. E* Trade
3. Quick and Reilly Group
4. Waterhouse Investor Services
   

1. Using the data in Exhibits 3, 4, 5, and 6 calculate the asset betas for comparable firms from Q3.
   

1. What is your estimate of the cost of capital for the Ameritrade’s planned investment? Provide all your assumptions.

1. Charles Schwab Corp, β = 2.337 (Oct 87- Aug 97)

Regression Output as shown below:

[pic 5]

1. E* Trade, β =         3.023 (Aug 96 – Aug 97)

Regression Output as shown below:

[pic 6]

1. Quick and Reilly Group, β = 2.427 (Feb 84 – Aug 97)

Regression Output as shown below: