Ameritrade case Essay

Submitted By xubuqing21
Words: 2139
Pages: 9


David Cao

Jane Xuejing Li

Mike Xu

Dongye Zhang


• Ameritrade was a deep-discount brokerage firm that planned to invest heavily in technology and advertising to increase customer base and brand awareness! • Needed an estimation of the risk of the investment to evaluate whether the strategy would generate sufficient future cash flows!
• Average ROE during 1975 to 1996 was 40% (except for two years). The most recent five years posted returns larger than 40%. !
• Deep-discount brokers such as Ameritrade are more sensitive to stock market fluctuations than full-service brokers!


Question 1: What factors should Ameritrade management consider when evaluating the expansion proposal? Why? 

!• Unclear cash flow and revenue

Budget for technology enhancement and marke=ng should increase accordingly with the growth of revenue.

• Labor cost occurred during expansion needs to take into account.

High ROE • Ameritrade has a 91% debt ra=o • Creditors would ask for a higher risk premium

Debt cost of capital • If there is a significant risk that the firm will default, the yield to maturity of the firm’s debt will overstate investors’ expected return.

Equity Cost of Capital • Underes=ma=ng cost of capital would result in overes=ma=ng future return

Stock market

• Decline in stock market would lead to decreased trading ac=vi=es and borrowing by investors, which would reduce Ameritrade’s revenue and its ability to pay debts


Question 2: How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for a real investment (as opposed to a financial investment)? 
 • ! Unlike a financial investment, a real investment normally has no historical data for es=ma=ng market risk premium

Iden=fy a comparable firm

Find a comparable firm in the same line of business as the new project Es=mate the cost of capital of the assets of comparable firms and then use that es=mate as a proxy for the project’s cost of capital

All-­‐equity financed firm vs unlevered firm •

All-­‐equity: use the comparable firm’s equity beta and cost of capital as es=mates for beta and the cost of capital of the project. Unlevered:

• the firm’s leverage makes the equity riskier and the beta not a good es=mate of the beta of its assets and of the project • Recreate a claim on the firm’s assets by holding both its debt and equity simultaneously and calculate the beta of the firm’s asset (it matches the beta of this porTolio)


Question 3A: Using the CAPM- What is your estimate of the riskfree rate to use for the cost of capital for Ameritrade? Why?

!Exhibit 3 from case: Capital Market Return