Cost of Capital at Ameritrade

The table below shows the equity betas for the firms presented in the case (using Jan-92 to Dec-96 equal weight NYSE/AMEX/NASDAQ as market portfolio):

Here we choose VW NYSE, AMEX, and NASDAQ data as market returns, because it’s value weighted and more reliable. The results show CSC’s equity beta = 2.27, QRG’s equity beta = 1.79.

Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.

Cost of capital is what it will cost the firm, on the margin, today, to secure its financial resources for further growth.

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

Risk free rate + Equity Beta * (Expected return on market - Risk free rate)

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

Since the company is newly listed in stock market, no sufficient historical data for the calculation of beta, so we selected the comparable companies Charles Schwab Corp (Discount Brokerage), Quick & Reilly Group (Discount Brokerage) and Waterhouse Investor Srvcs (Discount Brokerage). Because the operating business scope and the brokerage revenue percentage to total revenue for these companies are similar to the Ameritrade, we just use these companies’ historical data for the calculation of Ameritrade’s beta. *Note: Although E*Trade (Discount Brokerage) has the similar business scope with the Ameritrade, we excluded this company since the company strategy is not to be a discount brokerage.

In theory, CAPM is an asset pricing model which states that assets are priced commensurate with a trade-off between undiversifiable risk and expectations of return (Dempsey, 2013). It is based on certain assumptions like Modern Portfolio Theory, Arbitrage Pricing Theory (APT) and Efficient Market Hypothesis (EMH) where investors are assumed rational under the Market Rationality.

Beta is a measure of the market risk of a security or a portfolio in comparison to the market as a whole. It is used in the Capital assets pricing model (CAPM), which calculates the expected return, and assets based on its beta and expected market returns. The market beta is set at 1.00 and every stock is calculated by value line based on past stock price volatility. A beta of less than 1 indicates that the security will be less volatile than the market whereas a beta greater than 1 indicates that the security price will be more volatile than the market.

The CAPM model was developed by Sharpe (1964) to explain how capital markets set share prices. (Pike and Neale) In result of research by Sharpe (1964), Litner (1965) and Black (1972) the Capital Asset Pricing Model (CAPM) states “the relationship between beta (measure of volatility on portfolios/assets) and expected returns is linear, exact, and has a slope equal to the expectation of the market portfolio excess return”. CAPM makes the assumption that markets are efficient therefore suggesting that operators within the market have rational expectations, this assumption leads us to the first weakness of CAPM (Vernimmen, 2011). However, when estimating the cost of capital, CAPM is seen to be preferred compared to other asset pricing models simply due to its simplicity. In a survey conducted by the Association for Financial Professionals (2011) it was found that when estimating the cost of capital 87% of all firms and 91% of publicly traded firms used CAPM.

This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and

Capital asset pricing model was developed by Sharpe (1964) and furthered through the works of Lintner (1965), Mossin (1966), Treynor (1965) and Black (1972). This model calculates expected/required rate of return for any risky financial asset. Capital Asset Pricing Model formula is shown in figure 1.1. Essentially, this represents investors need to be compensated for their time value of money and risk. Beta is measure of volatility and will be further examined in later stages of this essay. For example, if our particular company has a high standard deviation of the rate of return, an investment in the company might appear

So, E (ri) is the cost of equity and the premium an investor should expect for taking on the additional

We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As