Investment and Market Risk Premium

Cost of Capital at Ameritrade Day 1 1. What factors should Ameritrade management consider when evaluating the proposed advertising curriculum and technology upgrades? Why? -They should see how revenues have changed after adopting the new ad program and technology upgrades -They engage to see ROI for their investments everyplace time 2. How can the Capital Asset Pricing Model be employ to estimate the court of capital (required reverberation) for calculating the net present value of a projects notes flows? it exit help us determine the Cost of capital or discount rate which we can drill to calculate NPV, in other terms the numerator will never change (FCF), only the denominator will found on the cost of capital3. What is the estimate of the unhazardous rate that should be employed in calculating the cost of capiual for Ameritrades proposed investment? the peril free rate should be the T-bills rate or the norm yearbookized total annual returns on US government securities = 3. %. In my opinion, we should expend the venture-free rate equal to yield of 20-year US government securities, because it is long-term capital investment. We may use 30-year rate, but we ar investing in technology, and c one timerning the zip of technological enhancements, 20-year rate is optimal. So it is 6,69% 4. What is the estimate of the grocery store insecurity premium that should be employed in calculating the cost of capital for Ameritrades proposed investment? Market Risk PremiumThree distinct concepts are part of securities fabrication risk premium 1) Required grocery store risk premium the return of a portfolio over the risk-free rate (such as that of treasury bonds ) required by an investor 2) Historical market risk premium the diachronic differential return of the market over treasury bonds and 3) Expected market risk premium the judge differential return of the market over treasury bonds. Also called loveliness premium, market premium and risk premium.Ma rket Risk Premium = Expected Return of the Market Risk-Free Rate The expected return of the market can be based on the SP 500, for example, while the risk-free rate is a great deal based on the current returns of treasury bonds. First to see to it the Expected Return of the market, from Exhibit 6, We dispatch the aggregate stock market and multiply by 12 = 15. 71% The Risk-free rate is 3. 8% =gt The market risk premium= 15. 7 3. 8 = 11. 9% (That is why we may use the digression mingled with US Government Securities rate (6,69%)and historical Large Company Stocks annual returns.But we have 2 bites during1950-96 and 1929-96. The difference between them is 1,3%. I think that we should use younger value of 14%, because the years 1930-1949, of course, were under market economy, but at the same time there were not so electrostatic laws, a Second World War passed, many companies at that time worked for government orders, so this number may be a bit out of overall tendencies. ) 5. In principle, how would one go nigh determining beta for purposes of calculating the cost of capital for Ameritrades proposed investment?TO calculate Beta for cost of capital, or plus beta We need to find first the Equity Beta = by regressing stock returns over market returns and it will then be the slope. We also need to calculate the market value of the equity of the firm which is the price per share multiplied by the total number of shares outstanding (see attached notes) A cost of capital is a weighted average of the cost of debt and equity. Likewise, the asset beta is the weighted average betas of debt and equity. We use market value proportions of debt and equity (see CAPM, p. 476). Ba = (D/D+E)BetaD+ (E/D+E)BetaEIt is common to assume that debt has no relationship to market risk that BetaD=0 Empirical studies of corporate debt returns suggest it would be better to grant some market-related risk to corporate debt and use estimates ranging from 0. 20 to 0. 30. To get BetaE, the equity beta for Ameritrade, we would normally express a regression of equity returns on stock market returns. That is, we would estimate the slope of the line that opera hat fits Unfortunately, Ameritrade had their IPO (Initial Purchase Offer) in March of 1997, so there is not enough data at the time of the case to calculate a reliable beta estimate.So instead, we will look at same firms. Firms in the same industry pursuing the same types of projects will have the same sorts of risks, thus their asset betas will be approximately the same. The returns we calculate for these firms, based on stock price movement, dividends, and stock splits, are their equity betas. These are influenced by the degree of supplement each company is using (recall that higher leverage leads to higher ROE, EPS and DPS, but also leads to greater variability in earnings).Knowing the amount of debt in their capital structures (at market values), we can calculate the asset beta for each comparable fir m. Then we will average these to use as a proxy for Ameritrades asset beta Note An agent that mediates sales and exchanges between securities buyers and sellers at even lower commission rates than those offered by a regular discount federal agent . As one might expect, deep discount brokers also provide fewer services to clients than amount brokers such brokers typically provide little more than the fulfillment of stock and option trades, charging a flatbed fee for each.The problem that must be overcome in determining the implementation decision is the dubiety of the cost of capital. Other Methods of Estimating Cost of Equity Capital The EP Method r = EPS / Stock Price The eternal Growth (Gordon) Model r = DIV1 / P 0 + g compute g from earnings, dividend, or cash flow growth or use the sustainable growth estimate ? Equity Betas, the relationship of a given equitys risk to that of the larger market, reflects two kinds of risk The risk of the communication channel itself The risk that the debt a business has will prevent cash flow to equity ?We can de-lever these equity betas to take apart out financial risk associated with leverage and find the implied beta for the business itself (asset beta) Asset beta measures the business risk only and does not change with capital structure ? Often, the best way to estimate a forward looking asset beta for a company is to take a median of its industry peers asset betas (historically calculated) since one-time company events in the past will be averaged out ? We can then find the equity beta for the company by re-levering the industry asset beta to the target debt / cap proportionality of the company ?Exhibit 4 provides various choices of comparable firms. Which firms do you recommend as the appropriate benchmarks for evaluating the risk of Ameritrades planned advertising and technology investments? Determine the betas for these firms. Let us agree that Charles Schwab is a comparable firm. Their price changes, dividen ds,and stock split information for 1992-1996 is in Exhibit 5. If there were no stock split, thereturn, compared to the former period, is given by For example, if the price the previous period was $100, then wentup to $104, and in addition had a dividend of $8, the return would be +0. 12, or 12%.In ashort time period, the returns will be much closer to 0. If there is an X for y stock split, use the formula Copy the Return values into Exhibit 6 on board the appropriate dates, then regress theSchwab returns against the value-weighted NYSE returns for the same period. The slopeof the line is the equity beta. Do this for the other comparable firms. Calculate the asset betas using the formula inquestion 5 (twice, once with Beta D = 0 and once with 25. 0). Average the results. This should be a good estimate of Ameritrades asset beta. Finally, put these results back into the equivalence in 2 to estimate Ameritrades cost of capital