Capital at Ameritrade Is One

¶ … Capital at Ameritrade Ameritrade is one of the successful brokerage companies in the U.S.A. today. Starting from 1975 it has been providing different types of brokerage services to its customers. Company was always among the first in the country to use technical innovations and services: "1988- Touch-tone phone trading is introduced. 1996- Ameritrade Holding launches eBroker®, an Internet-only broker and division of All American Brokers, Inc. 1998- Ameritrade introduces Darwin: Survival of the Fittest™, one of the first interactive, CD-ROM-based options trading simulators.

Ameritrade is one of the first brokerages to offer complex options order entry on the Internet. Ameritrade introduces electronic trade confirmations by e-mail." One of the characteristic features of the company is its deep belief in innovation technologies and high role of it-technologies in brokerage. Permanent investments in different types of services for clients such as "touch-phone," Internet based interface of the company, electronic stock-trade, etc. played a key role in preserving competitive positions in deep-discount brokerage and helped company to gain new markets.

it's a well-known fact that everything new, especially in the world of finances is often perceived with skepticism, as there is no 100% guarantee that innovations will boost profits and will be compensated. Such skepticism has a lot of common sense, as investment in it-technologies is quite risky because of high competition on the market of it-services and computer hardware and because of dynamic development of this market.

The need to reform company, taking advantage of emerging economies of scale prompted Chairman of Ameritrade, Joe Ricketts to expend company's customer base, which required considerable investments in customer support and other types of services, in order respond to the growing needs of company's customers.

As there is no definite strategy of company's investments to technology innovations and advertising, company needs to evaluate the risks of this project, as company's existing capital is not big enough to support such "experiments." In order to estimate required rate of return for Ameritrade potential projects we should use capital market data and CAPM (Capital Asset Pricing Model) for evaluations. Ameritrade's potential investments will yield cash flows for the next several years after company's reformation project will be fulfilled.

In order to evaluate the value of the cash flows at the present moment and in order to estimate whether such investment has a high potential we should first calculate cost of capital of the company. Capital assets pricing model provides all necessary data in order to calculate and evaluate the discount rate of the company. In order to estimate discount rate of the project, which is planned to be executed, we need to take into consideration economical life of the project and compare it with historical data.

Using data provided in Exhibit 3 of Cost of capital at Amritrade we can estimate market risk premium. Market risk premium defines return resulting from bearing risk (over and above risk-free rate). Market portfolio consists not only of stocks, but also of all assets. So we can measure market risk premium with stocks using the U.S. government bond returns. In order to choose the time period for market risk premium estimation we should take into consideration that long time series in statistics in general give more accurate results.

Also we should use large stock portfolio for estimation of market portfolio. So calculation of market risk premium will be the following: Historical average of annual return of large stocks - long-term U.S. government bonds over long period (1929-1996): MRP= 12.7% - 5.5% = 7.2% Evaluating Capital assets pricing model we should also calculate beta, which measures sensitivity of a stock's return to the return on the market portfolio. Evaluating "assets" beta we evaluate systematic risks of real assets cash flows.

Usually equity beta can be estimated from a regression test of stock market equity returns data. Because Ameritrade's Initial public offering was in March of 1997, the time series is to short for estimating beta (August 1997), as the provided data will give inaccurate results. That's why in order to estimate beta for Ameritrade correctly we can refer to the finance data of the comparable companies. It means that we should choose companies, which have cash flows with similar risk indexes, as these companies will have same asset beta indexes.

For running such test 14 different firms in 4 industries (investment services, Internet services, discount brokerage, internet) were chosen: A.G. Edwards, Bear Stearns, Lehman Brothers, MSDW, Paine Webber, R. James, Merrill Lynch, Mecklemedia, Netscape, Yahoo, Charles Schwab, E*Trade, Quick & Reilly, Waterhouse Investor Services. We can use the following formula to calculate beta for the firms above: In order to estimate reliable results we should choose firms, which specialize in brokerage services. Discount brokerage firms get considerable share of their revenues from brokerage commission activities (about 80%) and net interest revenues.

Understandably, these sources of income depend upon stock market activity. Discount brokerage firms, which will be our main focus, have activity similar to the activities of Ameritrade. Merrill Lynch on the hand with discount brokerage provides such services as asset management, investment banking and trading. We should not mainly focus on Internet service firms, as even though Ameritrade is planning to start it's own Internet services it can be classified as a real Internet firm.

The data of E*trade is not very reliable as its stocks have a very short history, so it can not be accurate enough for conducting a regression analysis. Stock prices and return data for Charles Schwab, E*Trade, Quick & Reilly, and Waterhouse Investor Services were used in order to make a regression analysis for beta calculations. Because too long periods may influence the stability of beta, we used data for the period of 4 years in order to run regression, which should provide reliable estimations.

Using equity betas data and data from exhibit 4 about capital structure we can evaluate average assets betas. After estimations we get the value of 2.1 for asset beta for Ameritrade (which represents estimated average value of betas for comparable.