Term Paper: Cost of Capital at TD Ameritrade

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¶ … Capital at Ameritrade

Ameritrade is faced with the decision of whether to invest in new technology at a cost of $100M and to support this with an advertising program that will cost $155M over the first two years.

There are several key factors that Ameritrade should evaluate when considering the proposed advertising program and technology upgrades. They need to take stock of their competitive situation, the environment, and the market.

Essentially, Ameritrade has identified a strategy that allows them to differentiate themselves from their competitors. They seek to become a low-cost provider and make their money on volume, as "the largest brokerage firm worldwide based on the number of trades," according to CEO Joe Ricketts. The question is whether or not this particular niche is going to be large enough to support their ambitions. This target market has specific needs and Ameritrade needs to understand exactly what those needs are. They believe price to be one need, and transaction speed to be another. However, they need to have a full understanding of the degree of demand elasticity there is on each of these features.

They also need to evaluate whether or not this new program of technology and advertising is going to deliver those results. This is the issue of return on investment on which Ricketts and his managers disagree.

Further, Ameritrade needs to consider what the source of these additional customers is going to be. They will need to significantly increase their market share in terms of trade volume in order to succeed with this new plan. Part of the issue is whether or not there are a sufficient number of these investors in the marketplace. Another part is what the response from their competitors is going to be. If Ameritrade is poaching customers from other brokerages, they will respond. One of the important issues in evaluating this investment is the considering of future cash flows. Should Ameritrade successfully increase its market share because the new technology gives them a competitive advantage, are they going to be able to sustain this advantage?

The target investor is not going to be brand loyal, if Ameritrade is to successfully lure them from their existing brokerage. Therefore, they are loyal to price and speed. If Ameritrade's competitors respond to this investment with investments of their own, so that they equal Ameritrade's speed and price, the advantage will be lost and the market share gains could be rendered temporary. However, it may also be true that such technological change is an inevitability so any advantage that can be gained - temporary or not - should be seized.

Another key issue is the nature of the risk they are undertaking. There is disagreement as to whether or not this investment should be valued as something pertaining to a brokerage firm, or to an Internet firm. This is important because it helps to accurately gauge the level of risk inherent in the investment. Ameritrade has long been a technological leader in the discount brokerage industry, but of late the Internet has been considered a business unto itself.

The Capital Asset Pricing Model can be used to estimate the cost of capital for a real decision as follows. CAPM estimates the risk of an asset by considering the degree of that asset's risk relative to market risk. Each asset will have specific risk factors and evaluation of these should be taken independently from the risk of the firm overall. In this case, Ameritrade is making a fundamental change to their firm. The risk level inherent in their previous investments is not necessarily indicative of the risk level of this particular investment for that reason. CAPM will attempt account for that by setting a discount rate appropriate to the level of the risk in this future investment, rather than the present discount rate that relates to past risk.

CAPM states that a risk of an asset equals the risk free rate of return plus the market risk multiplied by the risk premium (beta) of the given asset or company.

The risk free rate is generally considered to be the prevailing rate on government securities. In terms of this investment, the time frame is important. The investment that Ameritrade is making is long-term in nature and therefore needs to be compared to a risk-free investment with a similar timeline. You would use a current market rate because the comparison is two choices of investment to be made today. In this case, the two most appropriate time frames would be the five- and ten- year bonds, which have rates of 6.22% and 6.34% respectively. Given that the rates are similar, the shorter time frame is more appropriate. While Ameritrade is clearly spending this money to enact a long-term strategy, the business environment as it pertains to online brokerage services is changing with such rapidity that the new technology is likely to be rendered obsolete within the five-year time frame.

There are two views as to the market risk premium and beta that should be employed. A direct competitor, eTrade, views itself as an Internet business. ABN-Amro's analyst shared this view, comparing Ameritrade with firms like Yahoo and Netscape. The other view is that Ameritrade is a brokerage firm.

In evaluating this we must consider the degree to which each of these components (brokerage and Internet) affects Ameritrade's business. Historically, Ameritrade has been a broker. They have been a technological leader in the past, and it is assumed that in the course of those decisions they viewed themselves as a broker for the purposes of estimating the appropriate discount rate. Moreover, there is a fundamental difference between themselves and firms like Yahoo and Netscape. The latter are entirely Internet businesses. The growth of their businesses is closely related to the growth of the Internet itself. The growth of Ameritrade's business, however, is tied to the trading volumes on the stock market.

That said, the reason Internet companies are valued distinctly from non-Internet ones is that the Internet is changing how companies conduct business. In many industries, this has resulted in growth opportunities. If the industry grows as result of the Internet, and Ameritrade is the leader in Internet trading, it does not make sense to value them alongside strictly non-Internet companies. This investment by Ameritrade essentially changes the game of discount brokerage, so that in that sector at least, firms should be valued with some Internet component, as they are in future going to be dependent on the Internet for their revenues, as much as they are dependent on stock market trading volumes.

The market risk should be based on that for small companies, since that is Ameritrade's status, so 17.7%.

There are two ways in which to approach the issue of asset beta. Ameritrade's stock market beta is not a significant measure simply for the fact that the stock just started trading a couple of months previous. A measure then would be the betas for comparable firms. It is possible to use the beta of eTrade, a close competitor in the discount brokerage that is also employing technological innovation as a source of competitive advantage. Also, in the time since Ameritrade has gone public, it is traded in a similar pattern to eTrade, the exception being July when the latter firm posted a large gain while Ameritrade was stagnant. The similarities between the two firms suggest that they will over time track the market in a similar fashion. Other firms, such as Charles Schwab and Quick & Reilly, are in the same business but do not track as closely.

The only logical comparative for calculating an asset beta is eTrade. Ameritrade is not an Internet or technology company in that they do not develop technology and their business is not as dependent on the growth of the… [END OF PREVIEW]

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