Executive Summary: In mid-1997 Joe Ricketts the Chairman and CEO of Ameritrade, decided that Ameritrade’s new mission would be to become “the largest brokerage firm worldwide based on the number of trades. ” In order to accomplish this mission Ameritrade would need to invest significantly in technology and advertising. This strategy would require large expenditures relative to Ameritrade’s existing capital. In order to gauge the financial impact of these large expenditures, there needed to be some accounting for the riskiness of the project.
The average return on equity for Ameritrade from 1975 to 1996 was 40% and recent returns were much higher, with each of the most recent five years having larger returns than the 40% average. Ricketts understood that the plan would only create value if the investment returned more than it cost, but what was the cost of capital. The key questions to answer this problem are: 1. What is the estimate of the risk-free rate that should be employed in calculating the cost of capital for Ameritrade? Why? and 2. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade?
Why? The estimate of the risk free rate that should be employed in calculating the cost of capital is 6. 61%. This is the yield on the 30-year government bonds according to exhibit 3 in the appendix. We used this rate because we feel it is a safer rate to use than other shorter term rates and it will give us a more accurate depiction of the true cost of capital. The estimate of the market risk premium that should be employed in calculating the cost of capital is 11. 19%. We calculated this rate by using the historical average of small-caps at 17. 8% and subtracting out the risk free rate of 6. 1%. Write-Up: 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 a pioneer 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 two primary sources of revenue were from transactions and net interest. Which meant that virtually all of Ameritrade’s net revenue were 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. 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. 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. But what was the cost of capital? 1. As a general rule of thumb, the projected present value of future cash flows should be greater than the costs using the company’s cost of capital as the discounting factor.
Both of the programs involve risk and so the expected returns from the company increase. The programs undertaken must be able to reasonably fulfill the expectations of returns of the investors. The company wants to increase advertising in order to become the leader in reliable online brokerage services. Thus, it should take into account the best means of increasing its customer base (television, ad, newspaper, and magazine, online, mailing) through focused groups and the cost per each. Ideally it should invest in the best mix that results in increased revenue / $ spent on advertisement.
The increased revenue over costs after discounting at the cost of capital should result in a positive NPV. The company should consider the adaptability and compatibility of the technology. A more flexible, compatible technology will allow it to adapt with future technological needs and avoid having to invest in markedly different technologies in order to move towards their 100% reliability goal. The company should consider all the relevant costs to the technological upgrade: employee training, down-the-road costs, IT support, depreciation effect of Free Cash Flows.
Finally, the company should thoroughly evaluate the effect of technological upgrades on trade execution speed and reliability, when considering different technology investments. Understanding the customer preferences and the effect of proposed upgrade is vital as the company is trying to maintain 100% reliability. It is important that any changes be user-friendly as well. 2. The estimate of the risk free rate that should be employed in calculating the cost of capital is 6. 61%. This is the yield on the 30-year government bonds according to exhibit 3 in the appendix.
We used this rate because we feel it is a safer rate to use than other shorter term rates and it will give us a more accurate depiction of the true cost of capital. 3. The estimate of the market risk premium that should be employed in calculating the cost of capital is 11. 19%. We calculated this rate by using the historical average of small-caps at 17. 8% and subtracting out the risk free rate of 6. 61%. 4. As Ameritrade is a discount brokerage, the majority of its revenue is transactional and more susceptible to changes in the stock market than a full service brokerage.
From 1995 – 1997, an average of 68% of Ameritrade’s revenue came from transaction income (Exhibit 1). Therefore, to find firms with an equivalent level of risk, we looked at the brokerage revenues of the discount brokerage firms. E*Trade and Quick & Reilly are both discount brokerage firms with a high % of revenue from brokerage (95% and 81% respectively). Additionally, both E*Trade and Quick & Reilly are unlevered, which makes them more comparable to Ameritrade than other discount brokerage firms such as Charles Schwab and Waterhouse.