Joe Ricketts Case

Introduction

In March of 1997, Ameritrade raised $22.5 million in an initial public offering. Joe Ricketts, Chairman and CEO wants to improve his competitive position in the deep-discount brokerage sector and is considering investments in technology and advertising. The company needs to decide if the investment will generate enough returns to cover the cost of capital.

Capital Asset Pricing Model (CAPM)

Using the data provided in the case, we will evaluate using the Capital Asset Pricing Model (CAPM) taking into consideration factors such as the risk free rate, market risk premium and beta. As most analysts use 4-5 years of data (Ehrhardt, pg. 244), the time period we chose to use for all calculations is August 1991-July 1996. The CAPM describes how risk affects the rate of return. The more risky the investment, the higher the required return. It is dependent on the market, and that dependency is referred to as beta. If the beta is greater than 1, the stock return is variable and therefore risky, less than 1 would be the reverse or less risky. One objection to keep in mind as we use this model is that it is based on historic data. Assuming that what happens in the past will continue into the future (Keat & Young, 2009).

Since historical data is not available for Ameritrade, we will begin by looking at comparable firms. We grouped the discount firms together using Charles Schwab, Quick & Reilly, Waterhouse to determine an industry average beta, and did the same for the investment services sector. We assume that by dividing the firms into like sectors, we can average a beta assuming that they would be investing in like projects with similar risk. One caveat exists, we did not include E*TRADE due to the lack of information outlined in Exhibit 4.

We can then calculate the cost of capital using the CAPM model to determine the sector for discount brokerage and investment services according to the formula: rs = rRF+ (RPm) bi

Where:

rRF = the estimate risk-free rate

RPm = (rm-rrf) the estimate of the current market risk premium

(Bi)= Estimate of the stock's beta coefficient

Risk-Free Rate

Since there is no true risk-free rate to base the CAPM, we have chosen to use the 10-year Treasury bond rate of 6.34% (exhibit 3). The 10-year Treasury bond rate represents the sentiment and fear in the market, but it also offers the security and backing of the U.S. This rate represents an almost risk free return, and is as close to risk free as we can obtain in the calculation. A low rate would indicate that traders in the market are risk averse (Macke, 2012). Based on a survey, according to Brigham & Ehrhardt (2011) approximately two-thirds of highly regarded firms use this rate when using CAPM, thus for purposes of this analysis we will also use this rate.

Market-Risk Premium

To estimate market risk premium (required return on the stock market minus the risk-free rate), the approach we chose to use is based on the historic average annual returns of large company stocks and long-term bonds. These historic rates of return are acceptable to use in the calculation of the cost of capital as the length of time given (1929-1996) accounts for market high's and low's and on average should result in the returns reported in exhibit 3. From Exhibit 3, we determined the Market-Risk Premium using data from Historic Average Total Annual Returns for (1929-1996). Taking the Large Company Stocks rate of 12.7% and subtracting the Long Term Bonds rate of 5.5%, which resulted in a market risk premium of 7.2%, determined this rate.

Estimation of Beta

Beta measures a stock's tendency to move up or down with the market (Brigham and Ehrhardt, 2011). For this analysis