Ameritrade Case Essay Example

Merrill Lynch, A.G. Edwards, Paine Webber, and Raymond James had a similar percentage to Ameritrade's of 65%. Next, I refined the list by identifying firms with a debt-to-capital ratio comparable to Ameritrade's 91%, resulting in Bear Stearns, Merrill Lynch, and Paine Webber as potential options. It is crucial to select companies with de-levered capital structures to prevent underestimating calculations since debt increases equity beta.

The equity betas for Bear Stearns, Merrill Lynch, and Paine Webber are 1.81, 1.96, and 1.89 respectively. These figures were analyzed over a 5-year time period using the VW NYSE, AMEX, and NASDAQ return series as a proxy for the overall market portfolio. The reason for selecting a 5-year time period was to ensure enough historical data for accurate calculations and to avoid including outdated returns that may not accurately reflect the current market situation. The value-weighted index was chosen over an equal-weighted index because it provides a more accurate representation of the overall economic return of the portfolio and avoids excessive influence from a single security regardless of its market power.

Due to the limited price history of Ameritrade, spanning only 6 months and resulting in 5 returns, I decided to use the average beta of similar companies (1.89) as the equity beta. Calculating the beta based on the provided return figures for Ameritrade would be misleading (-1.36).

Exhibit 1 displays the asset betas of several comparison firms: Bear Stearns, Merrill Lynch, Paine Webber, and Ameritrade. The asset betas for Bear Stearns, Merrill Lynch, and Paine Webber are 0.87, 0.85, and 0.93 respectively. In contrast, Ameritrade has an asset beta of 0.39. The significant disparity in these values is attributed to Ameritrade's considerably

high debt/capital ratio when compared to the aforementioned firms.

Relative Inputs for Calculation of Cost of Capital

As previously mentioned, when calculating Ameritrade's equity beta, I took the average beta of three comparable firms due to insufficient information to accurately calculate Ameritrade's own beta. Utilizing a 5-year time horizon and considering the annualized market return and annualized return of 5-year bonds over the course of the last 46 years, we employed the CAPM to estimate the equity cost of capital at 0.32.

For the return on debt, I used a rate of 8.5%, which was based on Ameritrade managers reporting borrowing costs of 8-9%. In 1997, Ameritrade had an approximate tax rate of 35%.

By utilizing the provided information, I computed a weighted average cost of capital to be 0.08. The relatively low value is primarily attributed to Ameritrade's significant debt/capital ratio, resulting in a decreased emphasis on the cost of equity.