Ameritrade Holding Corporation (AMTD) is a deep-discount brokerage firm that has recently completed an IPO. Management at Ameritrade is considering substantial investments in technology and advertising to exploit emerging economies of scale, but is unsure of the appropriate cost of capital.
We can use capital market data and the Capital Asset Pricing Model (CAPM) to estimate the required rate of return for real investments. .
Evaluating Investments.
Ameritrade's potential investments are expected to yield cash flows over the next several years. To determine the present value of these cash flows and thus determine the attractiveness of potential investments, a cost of capital is required.
A firm maximizes its value by taking all positive NPV projects.
The CAPM.
The CAPM provides a framework for determining the discount rate.
Estimating the risk-free rate.
General guidelines. Reasonable people (financial analysts) can disagree.
Match to the economic life of the project.
This is a long-term project.
Current versus historical rates.
Use prevailing rate.
Exhibit 3 of the case: the current yield on long-term US government bonds is 6.61%.
Estimating the market risk premium.
Recall that the market risk premium measures the expected return of the market in excess of the risk-free rate required to compensate investors for risk of uncertain future cash flows.
While theoretically the market portfolio includes ALL assets, not just stock, we can approximate with stocks.
Proxy for the risk premium: stock market return - US government bond returns.
Estimating the market risk premium.
Historical data: should we use a long or short time series?.
Data should reflect overall economy throughout period of analysis.
Large stocks or small stocks?.
Large stock portfolio is better estimate of market portfolio.
Estimating the market risk premium.
Sensible choice?.
Use historical average annual return of large stocks minus long-term US government bonds over longer time period, 1929 - 1996.