Finance Ameritrade Is About to

Finance Ameritrade is about to make a substantial investment in new equipment and needs to estimate its cost of capital. The company has strong historic returns on investment of 40%, but uses a discount rate of 15%. One analyst has used a discount rate of 12%. Some managers think only the cost of debt is relevant, so they will need to have it explained to them why they are wrong. The company needs to make a determination about the cost of capital. Therefore, the company's financial managers must make some assumptions.

It is believed/recommended that Ameritrade will use a discounted cash flow analysis, with a net present value calculation, in order to make a determination about the financial merits of the project. Thus, the company needs to determine its cost of capital, and make estimates of the future cash flows. There are a number of factors that Ameritrade management needs to consider when evaluating the proposed advertising program and technology updates. The first thing, as the case notes, is the strategic implications.

Basically, if the deal makes any sense at all financial, Ameritrade is going to have to do it. Strategically, the company needs the new technology to maintain a competitive advantage over its closest competitors in the discount trading segment. In addition, Internet technology is rapidly evolving, so failure to make investments is technology will put the company at a disadvantage, especially if this failure allows competitors to execute trades faster or provide a better trading platform.

The stock market is improving at the time of the case, and volumes are growing -- it is important that Ameritrade takes advantage of this opportunity. Of course, the company also needs to take a number of financial factors into account. For the NPV calculation, the expected future cash flows are critical, as is the discount rate. The latter should reflect the opportunity cost of capital -- what the company might earn on other activities.

The project should have a net present value, meaning that it will add value to the company. A project that does not add value to the company should not be undertaken, and Ameritrade would need to seek out different ways of meeting its strategic objectives. 2. The capital asset pricing model can be used to estimate the cost of capital because it allows for an estimate to be drawn as to the company's cost of equity.

This can then be plugged into a weighted average cost of capital calculation along with the company's debt and, if relevant, preferred shares. The cost of equity reflects the company's risk in relation to the risk associated with the market in general. Investors will want the returns of the company to be commensurate with the risk that they are taking on, in order to justify that investment.

The capital asset pricing model is as follows: Ra = Rf + ?(Rm-Rf) That weighted average cost of capital is the discount rate that should be used to discount the expected future cash flows of the project to determine whether or not the project adds value to the firm. 3. The risk free rate is the rate of return that one would earn without taking on risk. The only securities that have no risk are short-term government securities.

There is no hard-and-fast rule about which Treasury rate should be used, but anything from three.