COST OF CAPITAL AT AMERITRADE

By:
Group 17
Ankita Susan Tigga 0067/52
Ankur 0068/52
Ankur Jain 0069/52
Ashish Meena 0070/52

1.

What are appropriate proxy companies and the reasons for this?

Ameritrade being a discount brokerage firm supplies services related to the trade, unlike other
brokerage firms which are involved in stocks. The two primary sources of revenue for
Ameritrade were from transaction and net interest.
Upon going through the Exhibit 4, we see that the 3 firms similar to Ameritrade (i.e. involved in
Discount brokerage) with sufficient stock price and return data (available for the past 5 years) are
Charles Schwab, Quick & Reilly Group and Waterhouse investor services. We also note that the
revenue structure of Ameritrade is somewhat similar to these 3 firms (i.e. approximately 90%
brokerage revenue for Ameritrade and 82%, 81%, 99% for Charles Schwab, Quick & Reilly
Group and Waterhouse investor services respectively). Hence these 3 firms seem to be the
suitable choices as proxy companies.
2.

Estimation of betas

For estimation of Betas, we have taken the previous 5 years data for the 3 proxy companies. The
risk free market rate has been taken from the exhibit 3 as 6.61% (Yield on US Government
Securities for 30 years).
We then use historical risk free rate to calculate risk premium in the market. From exhibit 3, we
take the historical average annual return for large company stocks as 12.7%. We chose this to be
the Market risk fluctuation of large companies will primarily determine the fluctuations in the
market. RF has been taken to be 5.5% which is the average annual return for long term bonds as
this represents return of bonds with highest maturity (20 years). Therefore the market risk
premium is given as
12.7% - 5.5% = 7.2%
The process of estimation of Beta involves running a regression Return on the all 3 companys
stocks and the market return during the corresponding time period. The slope then provides the
value of levered Beta (average of all 3 firms) as 2.56.
Upon un-levering the Betas (using market value of Debt/Equity) for the 3 firms, we obtain the
unlevered Beta as 2.21.
To lever the Beta again, we assume Debt of Ameritrade to be zero as Ameritrade has no interest
bearing debt. The Levered beta then becomes equal to the unlevered Beta, i.e. 2.21.
[Calculation of the aforementioned has been presented in the Excel Sheet attached]

3.

Estimation of Ameritrades cost of capital

To estimate the Ameritrades cost of capital, we employ the CAPM.

We have,
RE = RF + (RM RF )
Therefore,
RE = 6.61% + 2.21 * 7.2%
Hence RE = 22.53%
Since we have assumed the debt to be equal to zero, our R E represents the overall Cost of Capital
for Ameritrade. (Since in WACC, RD = 0)
WACC = 22.53%
4.

What is the justification for using the approach you have used?

The logic for some of the assumptions that we have made include:

We have not used E* trade as one of proxy firms even though it too is a Discount
brokerage firm with revenue structure similar to Ameritrade. This is because we do not
have enough data to estimate Beta for E* trade. The other 3 proxy companies are assumed
to accurately represent the market Beta.
We have taken the long term debt for Ameritrade as zero as seen from the balance sheet.
Also, since even the Income sheet does not indicate any Interest expenses, this
assumption seems reasonable.
The argument for taking Historic average returns from 1929 1996 is that there is a lot of
uncertainty in the future as well with economic recession or economic boom, both being
probable outcomes. Hence taking the largest period possible to maximize data points
seems to be the best choice.
We have taken the data for past 5 years since the debt to total capital ratios in Exhibit 4
are for the period 1992-1996. Also return on stock from exhibit 5 is present for all 3
proxy companies is present in exhibit 5.