Cost of Capital at Ameritrade Essay Example

Ameritrade acquired K. Aufhauser & Company which in 1994 launched the first internet trading site.

Professors Mark Mitchell and Erik Stafford prepared this case with the assistance of Research Associates Jose Camacho and Aldo Sesia as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www. hbsp. harvard. edu.

No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 1 201-046 Cost of Capital at Ameritrade Revenue Sources Exhibit 1 displays Ameritrade’s income statement for the fiscal years 1995-1997 and Exhibit 2 presents the balance sheet for 1996 and 1997. Ameritrade’s two primary sources of revenue were from transaction and net interest.

Transaction revenues consisted of brokerage commissions, clearing fees, and payment for order flow, which were cash payments received by Ameritrade for routing orders to execution agents. Interest revenues were generated by charging customers on debt balances maintained in brokerage accounts and the investment of customers’ cash segregated in compliance with federal regulations in shortterm marketable securities. Interest revenues were offset by interest payments to customers based on credit balances maintained in brokerage accounts. Virtually all of Ameritrade’s revenues were directly linked to the stock market.

Investors generally curtailed trading activity and their borrowing in response to sustained downward movements in the stock market. For

example, trading activity declined more than 20% in 1988 following the stock market crash of October 19, 1987. A substantial decline in the stock market could therefore lead to a steep decline in Ameritrade’s brokerage commissions and net interest revenues. Full-service brokers were less sensitive to market movements than deep-discount brokers like Ameritrade. Full-service brokers received asset management fees, which partially shielded the revenue stream from market declines.

Moreover, most full-service brokerage firms such as Merrill Lynch diversified their revenue stream by engaging in investment banking activities such as mergers and security underwritings. Planned Investments and the Cost of Capital Ricketts planned to grow Ameritrade’s revenues by targeting self-directed investors. Ricketts decided Ameritrade’s mission was ‘to be the largest brokerage firm worldwide based on the number of trades. ’ Ricketts’ strategy called for price cutting, technology enhancements, and increased advertising. First, Ameritrade would reduce commissions from $29. 95 to $8. 00 per trade for all Internet market orders.

There were currently no major players in this price range although many customers were price sensitive. To ensure competitors such as Charles Schwab and E*Trade did not follow Ameritrade’s lead and try to compete on price, Ameritrade would have to become the low cost provider of reliable online brokerage services. State of the art technology was the only way to prevent system outages and move towards the goal of 100% reliability. Therefore, up to $100 million would be budgeted for technology enhancements which also would increase trade execution speed - an important attribute to individual investors.

Finally, Ameritrade’s advertising budget would be increased to $155 million for the 1998 and 1999 fiscal years combined. In order to

gauge the financial impact of the advertising program and the investment in physical plant and technology, there needed to be some accounting for the project’s risk. The plan would only create value if the investment returned more than it cost. Surely the providers of capital would demand a return that reflected the riskiness of the investment. Joe Ricketts strongly believed that his role as CEO was to maximize shareholder value.

If the expected returns on investment were greater than the cost of capital, he was going to invest, even if there was a chance of bankrupting the firm. Ricketts felt that the expected return on investment was very high, on the order of 30% to 50%. But, he also knew that some members of his management team were not nearly as optimistic as he was, estimating the expected investment returns at only 10% to 15%. But what was the cost of capital? 2 Cost of Capital at Ameritrade 201-046 Recently, a CS First Boston analyst report employed a discount rate of 12% when evaluating Ameritrade.

The CFO at Ameritrade often used a 15% discount rate, while there were some managers at Ameritrade who felt that the borrowing cost of 8-9% was the appropriate rate by which to discount the future profit estimates. There was also the issue of the type of business that Ameritrade was in. Was Ameritrade a discount brokerage firm or instead a technology/Internet firm? A recent analyst report from ABN-AMRO valued Ameritrade on a comparables basis using Internet firms such as Yahoo, Mecklermedia, and Netscape.

In addition, E*Trade management continued to insist that E*Trade, while deriving all of its revenues from brokerage

operations, was not a brokerage firm, and thus should not be valued as such. Joe Ricketts hired a consultant to provide a cost of capital estimate that could be used in evaluating Ameritrade’s upcoming investments. Exhibits 3-6 provide information that was considered in estimating the cost of capital for Ameritrade. 3 201-046 Cost of Capital at Ameritrade Exhibit 1 Consolidated Annual Income Statements for the Fiscal Year Ending in September 1997 1996 1995 Net Revenues Transaction Income Net Interest Other Total Net Revenues