Marinade’s Cost of Capital Executive Summary After careful analysis of Amerada and comparable companies, I have estimated a 14. 784% cost of capital that should be used to evaluate Marinade’s upcoming investments in technology and advertising. After analyzing the historical return on Marinade’s investments, I have concluded that if the firm manages this project at least as well as its previous investments, the return on the proposed project will exceed the cost of capital resulting in a positive NP project.
Based on the estimated cost of capital, relative to the company’s historical returns on investment, I recommend that Amerada undertakes this investment project. I believe that the estimated cost of capital Is appropriate because It is partly based on a set of companies where the mall source of revenue Is similar to that of Amerada, deep discount brokerage companies. In addition, the nature of the project Is to Increase the customer base of Amerada, a frequent and archetypal venture for a deep- discount brokerage firm.
Because Amerada has very Limited data due to Its recent PIP, I will be using the comparable data of Waterholes Investors, Quick and Reilly Group Incorporated, and Charles Schwab Corporation to estimate Marinade’s levered beta using a bottom-up approach. I will be using these comparable because they are all characterized as deep-discount brokerage firms with similar sources of revenue. I used data from 1992-1996 because in my experience, I have found that five years of data provides a reasonable and precise measure of information.
It should be noted that I consistently used the same amount of data from five calendar years for all of Marinade’s comparable. The key stakeholders Involving this decision are management and those providing the capital, both debt and equity, for this new undertaking. For these stakeholders, priority Lies In the return of the Investment, the success of the company, and the ability to meet the financial obligations of the firm. These priorities can be best predicted with my provided estimation of the cost of capital in relation to the company’s historical return on investment.
Market Overview As Amerada continues to grow and make investments in projects, it is important to realize the effect the market has on the brokerage. One thing I want to emphasize is the direct correlation between the deep discount brokerage market and the stock market. While the S 500 during the last two years (1995 and 1 996) have had returns of 34. 11% and 20. 26% respectively, it is easy to be optimistic about the health of the economy and the performance of the company. In the case of an economic downturn, Amerada should be ready for a decrease In consumer activity and should consider diversification.
Perhaps taking on other types of activities such as investment banking roles Like mergers, calculations, and security underwriting old also be wise. This would diversify away some of the risk Involved In strictly deep-discount brokers. Amerada should also be conscientious of the very price- sensitive nature AT I TTS consumers when evaluating tens Investment. My calculated cost of capital is subject to a variety of factors affected by the uncertainty of the future. For instance, it is conceivable that the company’s beta will change over time due to the dynamic characteristics of the market and the economy.
In addition, stakeholders could change their comfort regarding the degree of risk aversion, which old affect the market risk premium. In order to mitigate the risk, Amerada could place a premium cost of capital on top of my estimated cost of capital when discounting future cash flows. This would mitigate the risk of future cash flows that are too optimistic in potentially harsh economic times. I believe that this would be an appropriate way to help stakeholders feel more comfortable with investments, especially investments as large as this advertising and technology project.
In order to estimate the cost of capital of Amerada, I had to determine standard ramset’s, such as beta, from comparable companies because of Marinade’s recent PIP and subsequent short track record of performance. I was able to obtain comparable companies’ betas by way of running a regression on the returns of the companies in relation to the return on the market, or the S 500. By applying Marinade’s capital structure to the comparable companies’ unleavened beta, I was able to approximate the beta of Amerada.
I was subsequently able to estimate the cost of equity assuming the same capital structure prior to the prospective investment with the Capital Asset Pricing Model (CAMP). I used CAMP to find the cost of equity for this particular project, not to evaluate the potential change in the process. The capital asset pricing model can be used in evaluation of the cost of capital because it reflects the reward for postponing consumption, the relative amount of systematic risk, and the reward in the market for bearing systematic risk.
Thus I can estimate the cost of capital using the true systematic risk. I believe that in the future, a capital structure consisting of more debt may lower the weighted average cost of capital and keep a larger proportion of the benefits of the project to he current stakeholders, while keeping in mind that Amerada should abstain from taking on too much debt considering its sensitivity to the market. I used three comparable companies to estimate Marinade’s cost of capital: Waterholes Investors, Quick and Reilly Group Incorporated, and Charles Schwab Corporation.
These deep-discount brokerage firms, along with Amerada, source most of their revenues through transactions and net interest. Situation Overview The WAC is a measurement of the rockiness of the firm as a whole and can be applied to standard company projects. Amerada has been first movers on introducing features such as an automated phone trading service and an online trading platform in the deep discount brokerage market. Both of these investments are characterized by substantial investments in technology, as is the proposed project.
Based on this, I consider the stated project as a typical project of the firm, yielding an average risk equal to that of Marinade’s nature. Therefore, I find that evaluating the stated project with WAC as a hurdle rate of whether to undertake the project is correct. One of the parameters that has a large effect on WAC is the UAPITA structure applied in the calculations. In my calculations of the WAC of 14. 783%, I assumed a debt to equity ratio of 0. 261.
I based this on the balance sheet numbers you provided me with for the two available years; it is a weighted? Average AT ten two years AT data when looking to ten market comparable Quickly Ana Reilly Group Incorporated and Charles Schwab Corporation, one can see that the debt to equity ratio of Amerada is an industry standard. I decided to omit Waterholes Investors for this comparison because of their atypical capital structure. In the ululation of the WAC, debt has the advantage that it brings a tax shield since interest on debt is tax deductible.
Therefore taking on more debt relative to equity can be profitable to a certain point where, cost of potential financial distress for undertaking that extra debt is less than the value of the interest tax shield. In addition, taking on too much debt carries the risk of major credit rating agencies downgrading the company, where eventually, debt becomes too costly because the cost of potential financial distress is greater than the value of the interest tax shield. Therefore, the management in the evaluation of the investment must have a clear focus on which capital structure is the optimal for Amerada in the future.