Cost of Capital at Ameritrade

Cost of Capital at AmeritradeCase Study Report

Since its formation in 1971, Ameritrade has established itself as a pioneer in the deep-discount brokerage sector. Ameritrade is currently proposing to improve its competitive position in this market via exploiting emerging economies of scale through substantial investments in technology and advertising. The purpose of this report is to provide an estimate of Ameritrades cost of capital in order to evaluate upcoming investments.

Yifan Cui z3330028 & Ken Liu zSemester 2, 2011

Factors the financing mix for the projects. Ideally, the financing mix chosen should minimize the cost of capital (and thus maximize project value) whilst allowing Ameritrade to maintain its target capital structure.CAPM for real investment decisions

The valuation models developed for financial investment such as CAPM are applicable for real asset investment as well. Real assets and financial assets share several common characteristics: their value is determined by the cash flows they generate, the uncertainty associated with these cash flows and the expected growth in the cash flows. CAPM is traditionally used to determine the cost of equity; a component of the cost of capital. Ameritrades cost of capital should reflect the risk premium to account for uncertainty of the expected future cash flows. CAPM provides a useful framework for determining the cost of capital, which serves as a benchmark as to whether the project should be accepted. To apply CAPM to real investment decisions, assumptions for calculating beta and risk premium can be modified, mainly because of differences in liquidity and the types of investors across the two markets. Traditionally, regression analysis of stock returns to the market portfolio is used to obtain the beta of a stock or financial asset. However, real asset investments are highly illiquid. This leads us find an index, listed on the exchange, containing comparable assets to the one being invested in.

The valuation models developed for financial investment such as CAPM are applicable for real asset investment as well. Real assets and financial assets share several common characteristics: their value is determined by the cash flows they generate, the uncertainty associated with these cash flows and the expected growth in the cash flows.

The Capital Asset Pricing Model (CAPM) = E(r) = Rrf + (Rm Rrf)

The Capital Asset Pricing Model (CAPM) is traditionally used to determine the cost of equity (the return equity investors demand from putting their funds into risky investments) which is a component of the cost of capital. It represents the minimum return we need to achieve to satisfy our equity investorsComponents of CAPM include: The risk-free rate (Rrf) Market risk premium (Rm Rrf) Beta

Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate for the risk-free rate. The market risk premium used in the cost of equity equation is forward-looking. While the market risk premium used in beta regression are historical realised for each stock return period.The market risk component, beta, can be measured using the regression analysis between the stocks return and the market portfolio. However, the short history of Ameritrade stock prices renders it inadequate. A more appropriate method would be a bottom up beta method. Steps to calculate bottom-up beta:1. Identify the business the firm operates in.2. Find other publicly traded firms in the same industry and obtain their betas, which are used to compute the average beta of the industry.3. Utilising the Hamada equation, we need to obtain the unlevered beta, a proxy of Ameritrades risk if the firm was entirely financed through equity.

Unlevered beta = beta comparable firms / [1+ (1-t) D/E comparable firms].4. Finally, taking into account Ameritrades leverage, capital structure, use the Hamada equation to compute its levered beta.

Further adjustment can be made for higher risk premium and compensation for liquidity for small firms.

CAPM assumes that marginal investors are well diversified and therefore are only rewarded for taking additional risk that cannot be diversified away (systematic risk). Systematic risk is represented by the beta and the market risk premium reflects the return required for taking risk above investments considered to be risk free.

Alternatively, to apply the CAPM model to real investment decisions, assumptions for calculating beta and the risk premium can be modified, mainly because of differences in liquidity across the two markets and in the types of investors in each market.

Traditionally, regression analysis of stock returns to the market portfolio is used to obtain the beta of a stock or financial asset. However, real asset investments are highly illiquid. The result is we do not observe the same periodic price changes like that of financial assets. This leads us find an index, listed on the exchange, containing comparable assets to the one being invested in.

Hence to estimate the beta, we must regress the market indexes return against the market portfolio. Traditionally, the market portfolio used in calculating a stocks beta contains all stocks and financial asset only and no real assets. A solution to this is to find an index indicative of all assets within the market which comprises of real investments. That is, a consolidated market portfolio.

For the final adjustment, we must consider whether investing in real assets exposes an investor to additional risks not experienced by financial investors and whether or not it is rewarded. An obvious distinction between the two types of investors is their level of diversification. CAPM makes the fundamental assumption requiring marginal investors be well diversified and hence only rewarded for the additional risk taken that is non-diversifiable. Since real assets tend to be large, expensive assets, real asset investors tend to possess little diversification. Therefore, adjustments to the risk factor, beta, to a total beta reflect the fact most real investors are not well-diversified.

Total beta = market beta/correlation between owners portfolio and the market.

2. How can the Capital Asset Pricing Model be used to estimate the cost of capital for a real (not financial) investment decision? The intuition behind CAPM is that the expected return on a stock is comprised of the risk free rate and the market risk premium. The market risk premium consists of both business risk or the firms sensitivity to business cycles and financial risk or the amount of long-term debt the firm carries. The more debt a firm holds the more susceptible to systematic risk the firm will be. For example, higher fixed interest payments will be especially detrimental to the firm during market recessions. The beta on a levered firm reflects both business and financial risk. Thus, CAPM concludes that a stocks risk premium is beta times the market risk premium. Adding the risk free rate will give us the cost of equity. The firms weighted average cost of capital is determined by taking the percentage of equity at market value times the cost of equity plus the percentage of debt at market value times the cost of debt minus taxes. Since CAPM gave us the cost of equity we only need the YTM on the firms outstanding debt to derive the WACC.

Estimating the risk-free rate and market risk premium

Computing asset beta using CAPM

Determining comparable firms

Calculating asset betas for comparable firms

Cost of capital

Conclusion

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