Case study Ameritrade
Cost of capital
Cost of capital Ameritrade
• Introduction to the case
• Calculate CAPM
• Calculate WACC
Company Background
• Ameritrade is forms in 1971
• Pioneer in the deep-discount brokerage
• In Mar 1997, Ameritrade raised $22.5 million in IPO
CAPM – Capital Asset Pricing Model
• Ke = Rf + B ( Rm – Rf)
• Risk free rate
• Beta
• Expected market return
• Market risk premium (Rf-Rm)
Exhibit 3 Capital Market Return Data
(Historical and Current)
CAPM Prevailing Yields on U.S. Government Securities (August 31,
1997)
Annualized Yield to
Risk free rate Maturity
- Using 30-years bond 3-Month T-Bills 5.24%
• Rf = 6.61% 1-Year Bonds 5.59%
5-Year Bonds 6.22%
10-Year Bonds 6.34%
20-Year Bonds 6.69%
30-Year Bonds 6.61%
Why?
• Ameritrade is going to make a substantial investment in technology
• Ameritrade’s mission is to be the largest brokerage firm worldwide.
Thus, long-term investment
CAPM
Market risk premium
Ameritrade is a large company
• Historic average total returns on US government securities and common
stocks. Historic Average Total Annual Returns on U.S. Government
• Rm = 14% Securities and Common Stocks (1950-1996)
Average Annual Standard
Ameritrade is a large company Return Deviation
• 1997, Ameritrade raised 22.5
T-Bills 5.2% 3.0%
Million in IPO Intermediate Bondsa 6.4% 6.6%
Long-term Bondsb 6.0% 10.8%
Large Company
Stocksc 14.0% 16.8%
Small Company
Stocksd 17.8% 25.6%
CAPM
Market risk premium
Rm (1959-1996) = 14%
Rf (30 year treasury) = 6.61%
Market risk premium = 14% - 6.61% = 7.39%
CAPM
Unlevered beta
• Average return price, compared to; VW, NYSE, and NASDAQ from Aug-31-
1997 to Aug-31-1992 => x-value, km (%) and y-value Ks(%) => regression
Charles Schwab Coefficients Standard Error
Intercept -0.00280594 0.017640836
X Variable 1 1.40430709 0.486186341
• Beta asset, Charles = .92/(.92+.08))*1.40+(.,08/(.08+.92))*(1-.35)= 1.40
• Beta asset, Quick & Reilly = 1.87
• Beta asset, Waterhouse = 2.23
• Average of the three beta asset = 1.83%
CAPM
Risk free rate (30 years bond) = 6.61%
Market risk premium (1950-1996) = 14% - 6.61% = 7.39%
Ameritrade Beta = 1.83
Ke = 6.61% + 1.83 (14% - 6.61%)
= 20.13%
WACC – Weighted Average cost of capital
• WACC is the cost of capital of the company.
• WACC is the rate that a company is expected to pay back to
shareholders.
WACC
WACC = E/ D+E* (Re) + D/D+E* (Rd) (1-t)
• E = market value of equity
• D = Market value of debt
• Re= Cost of equity
• Rd = Cost of debt
• T = corporate tax
Market Value of Debt/Equity
Debt/Value Debt/Capital
(Market Values) (Book Values)
Average Average
Firm Name (Industry) Current 1992-1996 Current 1992-1996
Bear Stearns (Investment Services) 0.60 0.50 0.69 0.60
Charles Schwab Corp (Discount Brokerage) 0.05 0.08 0.25 0.30
E*TRADE (Discount Brokerage) 0.00 NA 0.00 NA
Mecklermedia (Internet) 0.00 0.00b 0.00 0.00b
Quick & Reilly Group (Discount Brokerage) 0.00 0.00 0.00 0.00
Raymond James Financial 0.05 0.04 0.07 0.06
Waterhouse Investor Srvcs (Discount
Brokerage) NA 0.38 NA 0.70c
Debt and value ratios
Comparable
Date Firm Price # share Market cap D/E 1-(D/V)
Charles
29-Aug-97 Schwab 42.75 176,422.00 7,542,040.50 0.08 0.92
29-Aug-97 Quick & reilly 34.25 38,664.00 1,324,242.00 0 0
30-Sep-96 Water house 37.875 11,501.00 435,600.38 0.38 0.62
Total 114.875 226,587.00 9,301,882.88 46.00% 154.00%
Average 23.00% 77.00%
WACC
Assuming no debt
WACC = (Wd*Rd) + (We*Re*)
= (0.23*0) + (0.77*0.2) = 15.40%
Ameritrade cost of capital = 15.40%
