Cost of Capital at Ameritrade Harvard Case Analysis

The purpose of this case is to develop an understanding of how capital market data and the Capital Asset Pricing Model can be used to estimate the required rate of return for real investments. Each team is to prepare a written analysis of the case (maximum of 2 pages text) addressing the questions below. You may also include any additional charts, figures, or spreadsheet printouts as appropriate.
Key questions and concepts that your team should address:

1. What factors should the management consider in evaluating the proposed advertising program and technology upgrades?
2. How can the CAPM be used to estimate the cost of capital for an investment decision?
3. What is the estimate for the risk free rate and the market risk premium that should be employed in computing the cost of capital for Ameritrade? Justify your decisions.
4. Ameritrade cannot estimate its beta using its own historical data as the firm has been publicly traded for a short period of time. Exhibit 4 provides a choice of comparable firms. What comparable firms do you recommend as appropriate to determine the risk of Ameritrade’s planned technology and advertisement investments?
5. Please report the mean and standard deviation of returns and equity betas for each of the comparable firms you use.
6. Calculate asset betas for these firms, given the information in the case. Assume a 35% tax rate.
7. Estimate a cost of capital from this. How should Joe Ricketts, the CEO of Ameritrade view the cost of capital you have calculated?

Related: (Solution) MGMT 648 Applied Finance Week 1 Assignment

Solution – Cost of Capital at Ameritrade Calculations

Introduction

In this case study solution, we provide a step-by-step guide on how to calculate the cost of capital for Ameritrade using the Capital Asset Pricing Model (CAPM). This solution walks you through the calculation of each element, including the risk-free rate, market risk premium, and beta, and goes further to answer the key questions posed in the case. Additionally, we offer explanations and justifications for the assumptions made and the methodology used to ensure clarity in the approach. After performing the calculations, we analyze and interpret the results to assist in evaluating Ameritrade’s proposed investments in advertising and technology upgrades.

Ameritrade’s management should carefully evaluate the proposed advertising program and technology upgrades, particularly in terms of the expected return compared to the company’s cost of capital. By ensuring that these investments exceed the cost of capital, the company can generate positive Net Present Value (NPV) and create value for shareholders. Management should also consider the opportunity cost of capital—whether shareholders could earn a higher return by investing elsewhere. Furthermore, technological investments carry the risk of rapid obsolescence, and the success of the advertising campaign depends on its ability to drive significant customer acquisition and revenue growth.

The Capital Asset Pricing Model (CAPM) is used to estimate the cost of capital by incorporating three key inputs: the risk-free rate, the market risk premium, and the firm’s beta. In this analysis, we use the 5-year Treasury bond yield of 6.22% as the risk-free rate, which aligns with the medium-term horizon of the investments. Ameritrade’s projects—technology upgrades and advertising—are expected to last two to five years, making a 5-year bond the most appropriate measure.

To calculate the market risk premium, we use historical data from Exhibit 3. The historical return for large-cap companies from 1950 to 1996 was 14.0%, and the historical risk-free rate was 6.4%, resulting in a market risk premium of 7.6%. This figure represents the additional return investors expect for holding risky market assets rather than risk-free ones.

The beta of Ameritrade must be estimated using comparable firms, as the company has been publicly traded for a short period and lacks sufficient historical data. We select comparable firms from Exhibit 4, specifically Charles Schwab Corp., Quick & Reilly Group, and Waterhouse Investor Services, which derive significant portions of their revenue from brokerage services, similar to Ameritrade. These firms offer the most relevant comparison for assessing Ameritrade’s risk.

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