Corporate Finance

Ameritrade was proposing to embark on a strategy to improve their competitive position in the deep-discount market.  “The success of the strategy required Ameritrade grow its customer base” (Mitchell, 2000, p.1).  The proposal called for a $100 million in technology advancements and for $155 million for an increase in advertising budgets for 1998 and 1999 combined, which would be $77.5 million for each year.  Also included in this strategy was the targeting of the reduction of commissions from $29.95 to $8.00 per trade for all Internet market orders.  No specific period for the life of this project was stated.  It is assumed that the technology would take 1998 to implement, and the advertising budget was stated over two years.

In order to provide the perspective of risk on this project, the following must be considered:

1. Stock Market and Ameritrade Revenue Correlation – Ameritrade’s revenue is directly linked to the stock market, which means that good years will produce good revenues, while bad years will produce poor revenues.  This provides a high risk for Ameritrade, since 90.8% of the firms revenue comes from transaction income and interest revenues.
2. Commission Reduction – Transaction income for 1997 was $51,936,902 at $29.95 per commission, which accounts for approximately 1.73 million transactions in 1997. This would mean that a break-even point in transaction revenue would require approximately 6.5 million transactions for the year that this change is implemented.
3. Technology – It is hard to determine when revenues would be realized as a result of the technology based upon the building and releasing of the total technology model or a gradual implementation over the period of one to two years.  Most technology has a life of 4 years maximum.
4. Joe Ricketts Risk Position – In the proposal, it is obvious that Joe Ricketts is not risk adverse and he is very optimistic and the outcome, since he rates the return on investment from 40 to 50%.
5. Yearly Budget Impact – Granted that this is a capital project; however, there will be an impact on the yearly expenses and income statement.  There will be staffing required for the technology put in place, interest expenses on debt, etc.  All of these factors can reflect in cash flow, net income, and investor confidence.

On the positive side, Ameritrade has been consistently growing at a return on equity of 40%

Beta – Cindy Cleveland

Since we do not have the beta for Ameritrade, we need to find comparable firms and compute the betas of those firms.  The proportion of the revenue a firm earns from transactions and interest is related to the risk. To find the firms of comparable risks, we can look at the brokerage revenue of the brokerage firms.  From Exhibit 1, 90 % of the total net revenue of Ameritrade is from brokerage activities. Considering the brokerage revenue percentage in exhibit 4, Charles Schwab, Quick & Reilly and Waterhouse Investor appear to be the comparable firms. The levered betas were calculated using the excel slope function.  (See attached spreadsheet – Ameritrade Case Cindy Clevelend.xls for calculations.) The levered betas were 2.30, 2.20, and 3.18 for Schwab, Quick & Riley, and Waterhouse respectively.  The levered betas were the unlevered using the debt values for each firm (refer to exhibit 4). The results were 2.17, 2.20, and 2.27 for Schwab, Quick & Riley, and Waterhouse respectively. The betas were then averaged together to determine the beta that will be used for Ameritrade, which is 2.22.

Weighted Average Cost of Capital (WACC)

In an effort to effectively determine the capital structure of a project, the first steps that must be taken are to determine from the capital components (debt, preferred stock, and common equity) (Ref: Brigham, 2009, p. 309) how the project will be financed.  Reviewing the 1997 Balance Sheet, the following is shown:

[pic 1]

Obviously at this point, Ameritrade does not have debt.  This will not necessarily be so in the future.  In order to establish the WACC percentages, it is necessary first to compute the Retained Earnings Breakpoint.  This is defined as “the amount of capital beyond which new common stock must be issued” (Brigham, 2009, p. 320).  The following is the breakpoint:

[pic 2]

The suggested WACC should be made up of two capital components, which is comprised of 25% debt and 75% equity.   This would require an additional $54.8 million in Common Stock.

The next step is to develop an estimate of the expected rate of return.  Reviewing the comments in the case study with the optimistic rate of return on investment to be from 30% - 50% and 10% - 15%, I would suggest that 15% is the risk adverse expected rate of return that I will use. I have also chosen the risk free rate to be equal to the 10 year Bond, since this may be used as the life of the project.  This rate is 6.34%.

Using the Capital Pricing Asset Model (CAPM), I have concluded the following:

The cost of equity is set at 23.66%.

WACC

The next step is to calculate the WACC (Assumption: The tax rate is 40%) and the interest rate for the firm’s debt is 10%.  

There are two possibilities to the WACC (with many different combinations).  I have chosen two to provide a view of the project evaluation.

• View I – Debt Focus – Relying primarily on debt, a combination could be the weights of 75% for debt and 25% for cost of equity were chosen, since it yielded the best WACC and the fact that to raise a substantial amount of capital through a stock offering would take time.  Using the 25% would allow the use of the breakeven point for retained earnings to be used, while the remaining is through a stock offering.  Also in this consideration is that the advertising budget is spread over two years.  Based upon this, the WACC is calculated as:

• View II – Equity Focus – Relying primarily on equity may be viewed in the following allocation of 25% debt and 75% equity, which yields: