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Ameritrade’s Cost of Capital Essay

Executive Summary

After careful analysis of Ameritrade and comparable companies, I have estimated a 14.784% cost of capital that should be used to evaluate Ameritrade’s upcoming investments in technology and advertising. After analyzing the historical return on Ameritrade’s investments, I have concluded that if the firm manages this project at least as well as its previous investments, the return on the proposed project will exceed the cost of capital resulting in a positive NPV project. Based on the estimated cost of capital, relative to the company’s historical returns on investment, I recommend that Ameritrade undertakes this investment project. I believe that the estimated cost of capital is appropriate because it is partly based on a set of companies where the main source of revenue is similar to that of Ameritrade, deep discount brokerage companies.

In addition, the nature of the project is to increase the customer base of Ameritrade, a frequent and archetypal venture for a deep-discount brokerage firm. Because Ameritrade has very limited data due to its recent IPO, I will be using the comparable data of Waterhouse Investors, Quick and Reilly Group Incorporated, and Charles Schwab Corporation to estimate Ameritrade’s levered beta using a bottom-up approach. I will be using these comparables because they are all characterized as deep-discount brokerage firms with similar sources of revenue. I used data from 1992-1996 because in my experience, I have found that five years of data provides a reasonable and precise measure of information. It should be noted that I consistently used the same amount of data from five calendar years for all of Ameritrade’s comparables.

The key stakeholders involving this decision are management and those providing the capital, both debt and equity, for this new undertaking. For these stakeholders, priority lies in the return of the investment, the success of the company, and the ability to meet the financial obligations of the firm. These priorities can be best predicted with my provided estimation of the cost of capital in relation to the company’s historical return on investment.

Market Overview

As Ameritrade continues to grow and make investments in projects, it is important to realize the effect the market has on the brokerage. One thing I want to emphasize is the direct correlation between the deep discount brokerage market and the stock market. While the S&P 500 during the last two years (1995 and 1996) have had returns of 34.11% and 20.26% respectively, it is easy to be optimistic about the health of the economy and the performance of the company. In the case of an economic downturn, Ameritrade should be ready for a decrease in consumer activity and should consider diversification. Perhaps taking on other types of activities such as investment banking roles like mergers, acquisitions, and security underwritings would also be wise. This would diversify away some of the risk involved in strictly deep-discount brokers. Ameritrade should also be conscientious of the very price-sensitive nature of its consumers when evaluating this investment. My calculated cost of capital is subject to a variety of factors affected by the uncertainty of the future.

For instance, it is conceivable that the company’s beta will change over time due to the dynamic characteristics of the market and the economy. In addition, stakeholders could change their comfort regarding the degree of risk aversion, which would affect the market risk premium. In order to mitigate the risk, Ameritrade could place a premium cost of capital on top of my estimated cost of capital when discounting future cash flows. This would mitigate the risk of future cash flows that are too optimistic in potentially harsh economic times. I believe that this would be an appropriate way to help stakeholders feel more comfortable with investments, especially investments as large as this advertising and technology project. In order to estimate the cost of capital of Ameritrade, I had to determine standard parameters, such as beta, from comparable companies because of Ameritrade’s recent IPO and subsequent short track record of performance. I was able to obtain comparable companies’ betas by way of running a regression on the returns of the companies in relation to the return on the market, or the S&P 500.

By applying Ameritrade’s capital structure to the comparable companies’ unlevered beta, I was able to approximate the beta of Ameritrade. I was subsequently able to estimate the cost of equity assuming the same capital structure prior to the prospective investment with the Capital Asset Pricing Model (CAPM). I used CAPM to find the cost of equity for this particular project, not to evaluate the potential change in the process. The capital asset pricing model can be used in evaluation of the cost of capital because it reflects the reward for postponing consumption, the relative amount of systematic risk, and the reward in the market for bearing systematic risk. Thus I can estimate the cost of capital using the true systematic risk. I believe that in the future, a capital structure consisting of more debt may lower the weighted average cost of capital and keep a larger proportion of the benefits of the project to the current stakeholders, while keeping in mind that Ameritrade should abstain from taking on too much debt considering its sensitivity to the market. I used three comparable companies to estimate Ameritrade’s cost of capital: Waterhouse Investors, Quick and Reilly Group Incorporated, and Charles Schwab Corporation. These deep-discount brokerage firms, along with Ameritrade, source most of their revenues through transactions and net interest.

Situation Overview

The WACC is a measurement of the riskiness of the firm as a whole and can be applied to standard company projects. Ameritrade has been first movers on introducing features such as an automated phone trading service and an online trading platform in the deep discount brokerage market. Both of these investments are characterized by substantial investments in technology, as is the proposed project. Based on this, I consider the stated project as a typical project of the firm, yielding an average risk equal to that of Ameritrade’s nature. Therefore, I find that evaluating the stated project with WACC as a hurdle rate of whether to undertake the project is correct. One of the parameters that has a large effect on WACC is the capital structure applied in the calculations. In my calculations of the WACC of 14.783%, I assumed a debt to equity ratio of 0.261. I based this on the balance sheet numbers you provided me with for the two available years; it is a weighted? average of the two years of data. When looking to the market comparables Quick and Reilly Group Incorporated and Charles Schwab Corporation, one can see that the debt to equity ratio of Ameritrade is an industry standard.

I decided to omit Waterhouse Investors for this comparison because of their atypical capital structure. In the calculation of the WACC, debt has the advantage that it brings a tax shield since interest on debt is tax deductible. Therefore taking on more debt relative to equity can be profitable to a certain point where, cost of potential financial distress for undertaking that extra debt is less than the value of the interest tax shield. In addition, taking on too much debt carries the risk of major credit rating agencies downgrading the company, where eventually, debt becomes too costly because the cost of potential financial distress is greater than the value of the interest tax shield. Therefore, the management in the evaluation of the investment must have a clear focus on which capital structure is the optimal for Ameritrade in the future. Below I have done a sensitivity analysis of the WACC that should be applied in the evaluation of the investment project in relation to the capital structure.

D% – E%

10/90
20/80
30/70
40/60
WACC
14.54%
14.32%
14.11%
13.89%

Based on these calculations, I would recommend that management look into the optimal capital structure after the proposed investment. While keeping in mind the disadvantages of taking on too much debt, I would recommend a higher, though incremental, debt to equity ratio. I found Ameritrade’s after-tax cost of debt to be 7.28%. To find Ameritrade’s after-tax cost of debt, I collected the credit rating of Ameritrade’s outstanding debt through Standard & Poor’s credit rating agency. Ameritrade’s debt is currently rated at B+. The default spread on B+ corporate debt is listed at 5.01 on 10-year debt obligations. To find the cost of debt you add this number to the risk-free rate, which as of August 1997 is 6.69%, and multiply that number by 1 subtracted by the corporate tax rate of Ameritrade.

The corporate tax rate of Ameritrade I found to be 37.7%, by averaging Ameritrade’s tax rates over the two available years. It should be noted that the default-spread rate applied in my calculations are projected rates, not current rates (2014). The risk free rate of applied throughout my calculations is the annualized yield to maturity of a 20-year government T-bond has and has a yield of 6.69%. I have chosen to use this because I consider the proposed investment project a long-term investment. When choosing the risk-free rate, there can be no uncertainty about reinvestment rates in the calculations, meaning that one should use a zero-coupon bond with the same maturity as the project. The Market risk premium is defined as the difference between the expected return on the market portfolio and the risk-free rate; in other words, it is the compensation that risk adverse investors need to receive in order to invest in the market portfolio.

I calculated the current market risk premium by finding the geometric average of the return on the market subtracted by a 20-year government T-Bond. I used the geometric average because we are valuing the average over a long period of time and the arithmetic average tends to overestimate the value. I then found the beta by using a bottom-up analysis. The bottom-up approach tends to make the standard error of the beta much lower than other types of analyses. In addition, the bottom-up approach can reflect the current and the expected future beta of the company. I looked at the beta of the comparable companies and found the average of the betas over the 1992-1996-time period. I then had to un-lever the beta and then re-lever the beta by Ameritrade’s capital structure to find Ameritrade’s levered beta. By using this beta, I was able to calculate Ameritrade’s cost of equity to be 16.06% by using the Capital Asset Pricing Model.

In terms of the size of the investment, increasing advertising expenses to $155 million and technology expenses to $100 million is a huge undertaking for Ameritrade. If you look at your total assets at the end of 1996, you will see that it values at a little more than $400 million. Thus, the investments of this project would be 64% of Ameritrade’s total assets. When looking at the comparable companies Schwab, Quick and Reilly, and Waterhouse, a similar investment would only be 2%, 6%, and 21% of their total assets respectively. Because the investment is so large for Ameritrade, in comparison to its competitors, Ameritrade should be conscientious of the enormity of the project and require a higher proportional return. After consulting the database of Bloomberg Financial Records, I found that your return on assets and return on equity exceeded my estimated weighted cost of capital. Thus, I conclude that Ameritrade undertakes this project with full-invested confidence in the management.

Conclusion

My extensive research on Ameritrade and its comparable companies yielded an estimated 14.784% cost of capital for this project. Because of the nature of the proposed investment, I decided that the WACC would be applicable to the project. While this project may require a significant amount of resources, an optimistic return like the one you proposed and the historical average of your return on assets and equity would more than make up for the costs. Therefore my recommendation based on my calculations is that this is an attractive investment opportunity for Ameritrade, to grow its customer base and revenue, which the management should accept. However it must be taken into account that the beta and thereby the cost of equity I used to calculate the cost of capital were influenced by the comparable companies because I used data of these companies in my estimation of Ameritrade’s beta. Further the beta is estimated on historical return and not the future return. Consumer preferences and market conditions may lead to a change in Ameritrade’s beta over the projects lifetime.

Since the future is unknown estimating a historical beta is the best guess of what the future beta will be. The market risk premium that I have applied in my calculations is also a subject to the changes of the future. The market risk premium is the compensation a risk adverse investor needs in order to invest. In periods of economic and financial depression, this market risk premium will increase resulting in a higher cost of capital. On the other hand, periods with good economic and financial conditions will lower the market risk premium. Further the market risk premium applied in my calculation is based on a projected default spread (2014) instead of the actual spread in 1996; this may be a source of variability.

The capital structure of Ameritrade has a substantial effect on the cost of capital. In my calculations, I have applied the historical capital structure of Ameritrade. Increasing Ameritrade’s debt to equity ratio can bring down Ameritrade’s cost of capital. Therefore it would be in Ameritrade’s management best interest to look at the company’s future capital structure prior to this investment. Ameritrade’s management should also look into the projected revenues of the investment. With projections ranging from 10% to 50%, only the most pessimistic forecasts are lower than the cost of capital of the project.

However by cutting the transaction fees and thereby relying on a higher volume of executed trades can make Ameritrade even more susceptible to future economic depressions. As per my calculation, the size of the investment is proportionally large and must be treated in the most delicate manner. Ultimately, I suggest that management find the optimal capital structure before investing in this project. However, I do believe that with my calculated cost of capital in comparison to the average return on equity and return on assets, the investment will be a worthy venture.


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