Case Solution
Cost of Capital at Ameritrade
| | • Executive summary:
Formed in 1971 and listed in March 1997, Ameritrade has been one of the most successful players in the deep- discount brokerage sector. Ameritrade’s two major sources of revenue, Transaction income (brokerage commissions, clearing fees, and payment for order flow) and Net interest revenues that were generated from net balance of customers’ brokerage accounts and the investment of customer’s cash segregated in compliance with federal regulations in short term marketable securities contributes over 90% of its revenue.
The company management is now proposing huge capital
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c. Beta estimation - Select of data source Since the company is newly listed in stock market, no sufficient historical data for the calculation of beta, so we selected the comparable companies Charles Schwab Corp (Discount Brokerage), Quick & Reilly Group (Discount Brokerage) and Waterhouse Investor Srvcs (Discount Brokerage). Because the operating business scope and the brokerage revenue percentage to total revenue for these companies are similar to the Ameritrade, we just use these companies’ historical data for the calculation of Ameritrade’s beta. *Note: Although E*Trade (Discount Brokerage) has the similar business scope with the Ameritrade, we excluded this company since the company strategy is not to be a discount brokerage.
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Some modifications of the beta coefficient are the adjusted beta and the fundamental beta. The former tries to transform the historical beta closer to an average beta of 1.0. The latter seeks to incorporate information concerning the company to achieve a better estimate for beta. Moreover, beta values out of less-developed financial markets are not good estimates and therefore partly biased. Problems in estimating beta for divisions of a corporations could arise if the divisions are too small and therefore can be compared with less-developed financial markets. Hence, beta coefficients could be biased (Brigham & Daves, 2007).
After levering the equity beta, the asset beta of the firms are calculated. As mentioned we think that the three discount brokerages (highlighted in green) should be used as comparables for Ameritrade. The average asset beta of the three firms is 1.386. As a comparison the investment services firms have average asset beta of 0.603 and the one internet company (Mecklermedia) for which enough historical data is
As a deep-discount brokerage, Ameritrade planned to improve its competitive position by price cutting, technology enhancements, and increased advertising in mid-1997. Before initiating the plan, Ameritrade needed know whether the investment returned more than it cost. We were hired to estimate the cost of capital correctly. The key question is to find suitable comparable firms to estimate Ameritrade’s asset beta, since it was a recently-listed firm. We thought discount brokerage companies were best due to same revenue resources. Proper risk-free rate and market risk premium should also be chosen carefully, and we used 30-year bonds YTM and the annual return difference
* Stock Beta: Exhibit 5 shows a detailed measurement of the company’s stock returns in relation to the rest of the market through 5-year historical price and index data. The analysis includes monthly returns of both the NYSE and the S&P 500 index in order to capture a comprehensive view of the market return. In each comparison, the monthly returns of the Target stock and market are plotted on Y-axis and X-axis respectively to get the regression line’s slope or beta. The analysis arrives at an average beta of 0.988 which indicates a similar movement of Target stock’s returns in comparison to the whole market over time.
We use the equation ri=(Pt-Pt-1+Dt)/Pt-1 to calculate the monthly return of stock of Charles Schwab Corp, Quick & Reilly Group and Waterhouse Investor Srvcs. Then we have two methods to calculate the Beta of Equity for each company.
A common practice to determine the firm’s beta is to draw from historical data from published sources or compare numbers to competitors. In this case, Heinz can compare to Kraft, Campbell Soup and Del Monte and use professional judgement in determining the stock’s sensitivity to the market. A stock’s beta can be determined using a formula as well.
13. According to these three scatterplots, three-year data and three-month data both show the beta of holding Under Armour shares should be around 1.22~1.23. However,
Amongst General Mills’ competitors in the packaged foods and meats stock-market industry, General Mills has the lowest beta. Accordingly, since General Mills’ beta is below 1.0, the potential purchase of General Mills’ stocks acknowledges that the stock prices does not tend to change due to external factors in the stock market overall. Vice versa, if General Mills’ beta is above 1.0, stockholders experience the tendency of how external factors regarding the stock market possibly affects General Mills’ stock prices at any moment. Consequently, companies who have a beta above 1.0, is likely to be more risker if stockholders consider purchasing General Mills’ stocks.
Of these 6 comparable companies, 3 of them are kitchen and bath companies and the rest 3 deals with engines and generators. Hence an average of the asset beta has been taken for these two sub groups which represent different business segments. Finally to arrive at the asset beta which would reflect the riskiness/volatility of Kohler, weighted average of these two betas has been taken as provided in the calculations below:
The National Association of Securities Dealers Automated Quotations (NASDAQ) and the New York Stock Exchange (NYSE) are two of the largest and most known stock exchanges across the globe. Both of these stock exchanges handles and mediates the trade, sale, and purchasing of different stocks, bonds, and securities. While both of these stock exchanges have their own unique methods and forms of purchasing and selling stocks, they both serve the same purpose and function, which is a marketplace for the sales of stocks.
By using the company return and the Value Weighted Returns of the Market, we derived the companies’ levered equity betas and then unlevered them.
For estimation of betas, the above equation was run for the period from Jan, 2003 to Dec, 2006. Based on the estimated betas we have divided the sample of 63 stocks into 10 portfolios each comprising of 6 stocks except portfolio no.1, 5 and 10 having seven stocks each. The first portfolio 1 has the 7 lowest beta stocks and the last portfolio 10 has the 7 highest beta stocks. The rationale for forming portfolios is to reduce measurement error in the betas.
This yields a daily return of 0.05% and an annualized return for the NASDAQ of 18.09%. After this has been carried out, the daily and annualized standard deviations are also found for both MSFT and NASDAQ. The daily standard deviation for the same period is considered which comes to around 2.74% and then this amount is annualized to yield an annualized standard deviation of 52.29%. The same process gives a daily standard deviation of NASDAQ as 1.43% and annualized standard deviation is 27.35% (Figure 1). In order to find the beta associated with the company, the same amounts are used and the covariance of MSFT and NASDAQ re divided by the variance of the market which is NASDAQ. This leads to a beta of
Beta is calculated through the correlation between the return of the Kse index and closed ended mutual funds return with the aid of statistical formula.