Ameritrade’s Cost of Capital Case Study
Amerada management consider when evaluating the proposed advertising program and technology upgrades? Why? One factor that is significant and pertinent to this case is determining the cost of capital that should be employed for Amerada.
An appropriate discount rate is required to derive the net present value of the advertising program and technology upgrades.
With that said, estimating future cash flows should be based on investing activities, which include he initial cash outlays, salvage values and net working capital, and operating activities, which include forecasted changes in revenues and costs after taxes and depreciation. Taxes will either reduce operating profit or result in a tax credit if the firm experiences an operating loss. The depreciation method used will affect the amount of taxable income. Determining the project life and inflation are also critical parts of the capital budgeting decision.
How can the Capital Asset Pricing Model be used to estimate the cost of capital for a real investment decision? The intuition behind CAMP is that the expected return on a stock is comprised of the risk free rate and the market risk premium.
The market risk premium consists of both business risk or the firm’s sensitivity to business cycles and financial risk or the amount of long-term debt the firm carries. The more debt a firm holds the more susceptible to systematic risk the firm will be.
For example, higher fixed interest payments will be especially detrimental to the firm during market recessions. The beta on a levered firm reflects both business and financial risk.
Thus, CAMP concludes that a stocks risk premium is eat times the market risk premium. Adding the risk free rate will give us the cost of equity. The firm’s weighted average cost of capital is determined by taking the percentage of equity at market value times the cost of equity plus the percentage of debt at market value times the cost of debt minus taxes.
Since CAMP gave us the cost of equity we only need the YET on the firm’s outstanding debt to derive the NAACP. What is the estimate of the risk-free rate that should be employed in calculating the cost of capital for Amerada? Because it is an investment into genealogy I would suggest to take a bond with a duration which is not too long.
What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Amerada? Because Amerada belongs to the large companies we should use the large company stocks. But now we have to make an assumption due to the history of the stocks. We can take the average return of the shorter history or the longer history. Both has its advantages or disadvantages. When Nee want to simulate normal business we should use the short time history. This makes sure, that the great regression of the sass’s is not recognized.
UT otherwise regressions appear and the last ones we and in 2 . Therefore I would suggest to take the long term view within the regression of the sass’s and estimate a annual return of 12,7 % what leads too market risk premium of 6,36 %. In principle, what are the steps for computing the asset beta in the CAMP for purposes of calculating the cost of capital for a project? To control for both business ND financial risk, one must use an average industry beta of firms that have similar sensitivity to business cycles to calculate the asset beta.
The steps are as follows:
- Find a group of comparable.
- Find the beta of the comparable based on stock returns.
- Unlived the levered beta of comparable.
- Average the unleavened betas
- Lever the unleavened beta of your firm Amerada does not have a beta estimate as the firm has been publicly traded for only a short time period.
Exhibit 4 provides various choices for comparable firms. What comparable firms do you recommend as the appropriate benchmarks for valuating the risk of Marinade’s planned advertising and technology investments? He companies recommended as having similar business risk since they operate in the same industry are Charles Schwab, Quick and Reilly, and Waterholes. Discount brokers experience significant declines in transactions revenues during market downturns. Using the stock price and returns data in Exhibits 4 and 5, and the capital structure information in Exhibit 3, calculate the asset betas for the comparable firms. Ere levered betas are as follows: Charles Schwab Beta = 2.
3012, Quick and Reilly Beta = 2. 0505, and waterholes = 1. 2781.