Cost of capital at ameritrade case

Team Case #1

TD Ameritrade: Cost of Capital

TD Ameritrade; Cost of Capital - Complete this assignment as a group outside of class. Provide a typed written report of your analysis (not a list of answers to the questions). This should include a statement of the problem along with any issues you believe are relevant for your analysis. Use Exhibits, Tables or Figures to illustrate any calculations. Label and format them correctly (5 points). See the resources provided in the team case folder. Participation and team attendance are required for the case presentation and discussion on Wednesday, July 18th and are worth 10% of your grade.

1. (3 Points) Briefly describe the situation presented in the case. In doing this, be sure to address the following:

a. What does Ameritrade do?

i. Ameritrade is a deep-discount brokerage company that helps individual investors manage their portfolios in the deep-discount market.

b. Who is Joe Ricketts and what is his role in the company and regarding this WACC analysis?

i. Joe Ricketts is the Chairman and CEO of Ameritrade Holding Corporation, he is trying to figure out the Optimal Capital Structure.

c. Summarize recent developments with Ameritrade. Why do they want to calculate their cost of capital, and why are they hiring a consultant to do the calculation?

i. Ameritrade wants to improve their competitive position, so they are hiring an outside consultant to provide a cost of capital estimate that could be used in evaluating Ameritrade’s upcoming investments. Recent developments with Ameritrade include Ricketts plan to grow the company’s revenues by targeting self-directed investors.

2. (6 Points) Discuss the following issues related to WACC (cost of capital):

a. What is the WACC and why is it important for Joe Ricketts and Ameritrade?

i. The WACC is the weighted average cost of capital, the cost of growth for a company and their projects. It is important to Joe Ricketts and Ameritrade because it will tell them important capital expenditures when deciding to finance projects, the cost of funds, and the return of the projects at hand.

b. Is a firm’s WACC set by managers or investors? Explain.

i. A firm’s WACC is set by the investors when they calculate and make a decision on whether or not they want to invest into the firm. It tells them the minimum rate of return at which a company produces for its investors.

c. Is it possible to determine the exact cost of capital? Why or why not?

i. It is not possible to determine the exact cost of capital because

3. Calculate Ameritrade’s cost of equity using the SML (CAPM). In doing so, it is necessary for you to identify the appropriate risk-free interest rate, the appropriate beta, and the appropriate value for the market risk premium. Use the information provided in the case, discuss the alternatives for each and make your decisions. Use your textbook as a reference and use what you have learned in class. Justify your choices. Show your calculations in Tables or Exhibits.

a. Ameritrade had a recent IPO (just before the case was written) and does not have sufficient stock returns to estimate their beta.

i. Use the Pure Play method to estimate Ameritrade’s beta. Market value capital structure ratios (Debt/Value) are given in the case for competitors. Note that this is the Debt Ratio, NOT the Debt/Equity ratio.

ii. Comparable firm betas (in 1997): Charles Schwab = 2.00, Quick & Reilly = 2.23, Waterhouse = 1.8.

iii. Comparable firm tax rates (in 1997): 25% for all three comparable firms.

iv. Ameritrade currently does not have any LT Debt. However, they expect to raise funds using LT Debt for their planned technology investment. Use this value (provided in the case) for the market value of debt for both this calculation and WACC.

Exhibit 1: Ameritrade’s Estimated Beta:

Exhibit 1a: Comparable Companies Variables

Comparable Company

Market Value

Beta

Tax Rate

Charles Schwab

80%

2

25%

Quick & Reilly Group

(no debt) 0%

2.23

25%

Waterhouse Investor

38%

1.85

25%

Note. - Sources: Ameritrade Case Study, Question 3.A.ii.

Exhibit 1b: Comparable Companies Unlevered Betas

Charles Schwab:

bu = 2.0/[1+(1-25%)*(.08/.92)

bu = 1.8776

Quick & Reilly Group

bu = 2.3/[1+(1-25%)*(0/1)]

bu = 2.23

Water House Investors

bu = 1.85/[1+(1-25%)*(.38/.62)]

bu = 1.2674

Exhibit 1c: Average Unlevered Beta of Ameritrade

______________________________

Ameritrade

______________________________

buAvg. = (1.877+2.23+1.2674)/3

buAvg. = 1.797

______________________________

Exhibit 1d: Finding Debt and

4. (3 points) Ameritrade is not currently paying a dividend so the DDM calculation for cost of equity is not useful. Explain why Ameritrade may not be paying a dividend currently (in 1997).

a. Some companies may not pay a dividend if its directors believe that it's better to put the business's profits to work making the business itself more valuable. Another reason is that the company might not be financially stable, and do not have extra money to redistribute to their shareholders. It could also be due to tax purposes

5. (5 points) Find Ameritrade’s cost of debt using the information provided in the case. Use the information given in the case to find the company tax rate and calculate after-tax cost of debt. Use the average tax rate from the last three years.

a.

6. (15 Points) Calculate Ameritrade’s WACC using your results from parts 3. and 5. (above) and case information. Describe and explain what you have done. Show all calculations in a Table or Exhibit.

a.

7. (6 points) Be prepared to explain your results (in class) to Joe Ricketts when you present him your estimate for Ameritrade’s cost of capital (WACC).

a. Prepare a 1-2 minute summary to present your WACC findings to Joe Ricketts. Include your presentation summary here that you will present in class.

b. All members should be prepared to discuss the team’s WACC analysis including justification for assumptions made and inputs used in your calculations.