Ameritrade Cost of Capital

In 1997, the Chairman and CEO of Ameritrade Holding Corporation, Joe Ricketts, wanted to improve Ameritrade's competitive position in the deep-discount brokerage market. In order to accomplish this goal Ameritrade would have to grow its customer base. In order to acquire the necessary customer base Ameritrade would need to make significant investments in technology and advertising. Ricketts planned to grow Ameritrade's revenues by targeting self-directed investors, even defining Ameritrade's mission 'to be the largest brokerage firm worldwide based on the number of trades.' This strategy would require large expenditures relative to Ameritrade's existing capital. In order to evaluate whether the strategy would generate sufficient future cash flows to merit the investment, Ricketts needed an estimate of the project's risk.

Ameritrade has been in the deep-discount brokerage sector, since it formed in 1971. Ameritrade not only helped to create the deep discount market but it also was the first to offer many new services that changed the way individual managed their portfolio. The average return on equity during 1975 - 1996 was 40% and recent returns in the last five years were much larger than the 40% average. In March 1997, Ameritrade raised $22.5 million in an initial public offering allowing the company to continue adopting the latest advances in technology and to increase advertising to build its brand and improve market share.

Ameritrade's two primary sources of revenue were from transactions and net interest. This meant that virtually all of Ameritrade's net revenue was directly linked to the stock market. Ameritrade therefore was much more sensitive to declines in the stock market than the full-service brokers. Many of these full service brokers were shielded from sharp declines in the market because they diversified their income stream through asset management fees, and investment banking activities.

Joe Ricketts strategy called for price cutting, technology enhancements and increased advertising. They first reduced the commission on a trade from $29.95 to $8.00. They then budgeted $100 million for technology enhancements which also would increase trade execution speed. And, finally Ameritrade increased its advertising budget to $155 million for the 1998 and 1999 fiscal years combined. This plan would only be successful if the investment returned more than it cost. Joe Ricketts believed that his role was to maximize shareholder value and he was committed to invest in this project if the expected returns on the investment were greater than cost of capital. Joe felt the expected returns on investments would be 30 to 50%. The cost of capital would need to be calculated to determine if the project was worth investing in.

Estimating the Cost of Capital

Using CAPM to estimate the cost of capital we need to determine the following:

* Average Beta for Ameritrade

* Risk Free Rate

* Market Risk Premium

Beta

Since we do not have the beta for Ameritrade, we need to find comparable firms and compute the betas of those firms. The proportion of the revenue a firm earns from transactions and interest is related to the risk. To find the firms of comparable risks, we can look at the brokerage revenue of the brokerage firms. From Exhibit 1, 90 % of the total net revenue of Ameritrade is from brokerage activities. Considering the brokerage revenue percentage in exhibit 4, Charles Schwab, Quick & Reilly and Waterhouse Investor appear to be the comparable firms. The levered betas were calculated using the excel slope function. (See attached spreadsheet for calculations.) The levered betas were 2.30, 2.20, and 3.18 for Schwab, Quick & Riley, and Waterhouse