Cost of Capital at Ameritrade: A CAPM Case Analysis
This paper analyzes the cost of capital for Ameritrade, a leading U.S. deep-discount brokerage firm, in the context of a proposed major investment in advertising and technology infrastructure. Using the Capital Asset Pricing Model (CAPM), the paper estimates Ameritrade's market risk premium at 7.2% (derived from 1929–1996 historical data) and calculates an asset beta of approximately 2.1 using regression analysis of comparable discount brokerage firms. Because Ameritrade carries zero debt, its cost of equity equals its opportunity cost of capital, yielding an estimated cost of capital of 21.5%. The paper concludes that any project Ameritrade undertakes must return more than 21.5% to be considered worthwhile, and assesses the tension between management's optimistic projections and more conservative analyst forecasts.
- Ameritrade: Background and Innovation: Company history and commitment to technology innovation
- The Need for Capital Evaluation: Why CAPM is needed to assess investment risk
- Estimating the Market Risk Premium: MRP calculated at 7.2% from historical data
- Beta Estimation via Comparable Companies: Asset beta of 2.1 derived from peer regression
- Calculating the Cost of Capital: Cost of capital and equity both equal 21.5%
- Project Viability and Analyst Outlook: Management optimism versus analyst caution assessed
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What makes this paper effective
- Grounds each methodological choice — such as selecting a long historical period for MRP and using comparable firms for beta — in a stated rationale, making the analytical logic transparent.
- Acknowledges data limitations honestly, noting that Ameritrade's short IPO history prevents a direct beta regression and justifying the pivot to comparable companies.
- Closes with a practical judgment: comparing the derived 21.5% cost-of-capital threshold against both management's optimistic forecasts and the more cautious analyst consensus.
Key academic technique demonstrated
The paper demonstrates applied use of the Capital Asset Pricing Model by working through each input — market risk premium, asset beta, and leverage — step by step and clearly stating the formula and data source for each. The use of comparable-company analysis to proxy Ameritrade's unobservable beta is a standard corporate-finance technique that the paper executes and explains clearly.
Structure breakdown
The paper opens with company context and motivation for the study, then transitions to methodology (CAPM framework, MRP calculation, beta estimation via regression on peer firms), followed by the core result (21.5% cost of capital), and concludes by applying that result to assess the proposed investment's likelihood of success. The structure mirrors a standard capital-budgeting case analysis.
Ameritrade: Background and Innovation
Ameritrade is one of the most successful brokerage companies in the United States. Since its founding in 1975, it has provided a wide range of brokerage services to its customers. The company has consistently been among the first in the industry to adopt technical innovations: touch-tone phone trading was introduced in 1988; eBroker®, an Internet-only brokerage division, was launched in 1996; and in 1998, Ameritrade introduced Darwin: Survival of the Fittest™, one of the first interactive, CD-ROM-based options trading simulators. That same year, Ameritrade became one of the first brokerages to offer complex options order entry on the Internet and introduced electronic trade confirmations by email.
One of the company's defining characteristics is its deep commitment to information technology and its central role in brokerage services. Sustained investments in client-facing innovations — including touch-tone phone interfaces, Internet-based trading platforms, and electronic stock trading — have been critical to maintaining competitive positions in the deep-discount brokerage segment and to capturing new markets. However, everything new, particularly in the world of finance, is often met with skepticism, since there is no guarantee that innovations will boost profits enough to justify their cost. Such skepticism is well-founded: investing in information technology carries significant risk due to intense competition in the IT-services and computer-hardware markets and the rapid pace of technological change.
The need to reform the company and take advantage of emerging economies of scale prompted Ameritrade's Chairman, Joe Ricketts, to expand the company's customer base. This expansion required considerable investments in customer support and other services to meet growing customer demand.
The Need for Capital Evaluation
Because there is no definitive strategy for the company's planned investments in technology and advertising, Ameritrade needs to evaluate the risks of this initiative carefully. The company's existing capital base is not large enough to support such an undertaking without rigorous financial analysis.
In order to estimate the required rate of return for Ameritrade's potential projects, this analysis uses capital market data and the Capital Asset Pricing Model (CAPM). Ameritrade's potential investments are expected to generate cash flows over several years following the completion of the reform project. To evaluate the present value of those cash flows and to determine whether the investment is financially sound, the company's cost of capital must first be calculated.
The Capital Asset Pricing Model provides all the data necessary to calculate and evaluate the discount rate applicable to the project. Estimating the discount rate requires taking the economic life of the project into account and comparing it with historical data.
Estimating the Market Risk Premium
Using data from Exhibit 3 of the Harvard Business School case Cost of Capital at Ameritrade, it is possible to estimate the market risk premium (MRP). The market risk premium represents the additional return an investor earns from bearing market risk above and beyond the risk-free rate. Because the market portfolio includes all assets — not just stocks — U.S. government bond returns serve as a practical proxy for measuring the risk-free component.
To select the appropriate time period, two principles apply: longer time series generally produce more statistically reliable estimates, and a large stock portfolio should be used to approximate the market portfolio. Using historical annual returns for large stocks and long-term U.S. government bonds over the period 1929–1996, the market risk premium is calculated as follows:
MRP = 12.7% − 5.5% = 7.2%
This figure of 7.2% represents the estimated compensation investors require for bearing systematic market risk and will serve as a key input in the CAPM calculation.
References
Mitchell, Mark, and Erik Stafford. Cost of Capital at Ameritrade. Harvard Business School, April 26, 2001.
Ameritrade. Company History.
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