Cost Of Capital Ameritrade

Ameritrade's management should consider the net present value of the proposed advertising program and technology upgrades. They need to make sure that the future cash inflows due to this project outweigh its future cash outflows. Additionally, the riskiness of the project would have to be determined. Ameritrade's managers should also consider what taking on these programs would do to its capital structure. They might have a certain debt to equity ratio they wish to maintain, or perhaps there would be covenants put on their contracts requiring them to maintain a certain debt to equity ratio while their loan was outstanding.

Ameritrade should use a 6.10% risk free rate when calculating its cost of capital. This is the average of the 20 year bond annualized yield to maturity (on August 31, 1997) and the long term historical average annual return (from 1929 - 1996). The long term bond return was used because it provides an accurate average annual return since it reflects many years. The 20 year bond as of August 31, 1997 was used because it is the current yield to maturity. They were averaged in order to get a rate that would reflect current rates, but also be more reliable since it involves data from many years.

Ameritrade should use a 1.3% market risk premium. In order to derive that, the average risk free rate of past years was subtracted from the average weighted return of the market from past years. This was done to accommodate for fluctuations in the market.

Charles Schwab, Raymond James, Quick &Reilly, A G Edwards, and Mecklermedia, were used as benchmarks for evaluating the risks of Ameritrade's planned advertising and technology investments. Charles Schwab was chosen because they are Ameritrade's closest competitor. The other companies were chosen because they had similar debt to equity ratios as Ameritrade. These firms focused more on equity than debt.

The asset betas for each of the benchmark firms were calculated by taking the excess historical returns of each firm and running a regression to compare those returns with the market premium. The market risk premium was calculated by subtracting the risk free rate from the market returns. The regression gave us equity betas, so in order to convert them to asset betas they needed to be unlevered. See attached spreadsheets for the regressions results and the