Investment and Market Risk Premium

Cost of Capital at Ameritrade Day 1 1. What factors should Ameritrade management lease when evaluating the proposed advertising program and technology upgrades? Why? -They should see how revenues have diversifyd by and by adopting the new ad program and technology upgrades -They need to see ROI for their enthronisations everywhere time 2. How can the Capital Asset Pricing Model be wasting diseased to estimate the cost of slap-up ( need happen) for calculating the net bequest value of a projects cash ranges? it will help us train the Cost of outstanding or discount rate which we can part to mastermind NPV, in other terms the numerator will never change (FCF), only the denominator will based on the cost of cap3. What is the estimate of the unhazardous rate that should be employed in calculating the cost of capiual for Ameritrades proposed investment? the venture free rate should be the T-bills rate or the median(a) yearbookized total annual give-up the ghosts on US government securities = 3. %. In my opinion, we should use the risk of infection-free rate equal to yield of 20-year US government securities, because it is long capital investment. We may use 30-year rate, but we are investing in technology, and concerning the speed of technological enhancements, 20-year rate is optimal. So it is 6,69% 4. What is the estimate of the grocery risk premium that should be employed in calculating the cost of capital for Ameritrades proposed investment? Market Risk supportThree distinct concepts are part of commercialise risk premium 1) Required commercialize risk premium the exit of a portfolio over the risk-free rate (such as that of treasury bonds ) required by an investor 2) Historical foodstuff risk premium the historical differential coefficient return of the market over treasury bonds and 3) Expected market risk premium the expected differential return of the market over treasury bonds. Also called impartiality premium, market premium and risk premium.Market 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 often based on the flowing returns of treasury bonds. First to knock the Expected Return of the market, from evidence 6, We exact 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 difference among US Government Securities rate (6,69%)and historical Large Company Stocks annual returns.But we have 2 numbers during1950-96 and 1929-96. The difference between them is 1,3%. I specify that we should use younger value of 14%, because the years 1930-1949, of course, were under market economy, but at the akin time there were non so stable 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 peerless go near determining important for purposes of calculating the cost of capital for Ameritrades proposed investment?TO calculate Beta for cost of capital, or asset important We need to find first the rightfulness 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 paleness of the firm which is the charge 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 fairness. 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 set up 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 run a regression of equity returns on stock market returns. That is, we would estimate the slope of the line that best fits Unfortunately, Ameritrade had their initial offering (Initial Purchase Offer) in March of 1997, so there is not fair to middling data at the time of the case to calculate a unquestionable beta estimate.So instead, we will look at equal firms. Firms in the same industry pursuing the same types of projects will have the same sorts of risks, gum olibanum 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 tot of debt in their capital structures (at market values), we can calculate the asset beta for each comparable firm. Then we will average these to use as a proxy for Ameritrades asset beta Note An constituent that mediates sales and exchanges between securities buyers and sellers at even lower commission grade than those offered by a regular discount broker . As one might expect, deep discount brokers also provide fewer function to clients than standard brokers such brokers typically provide little more than the fulfillment of stock and option trades, charging a flat fee for each.The problem that must(prenominal) be overcome in determining the implementation decision is the indecision of the cost of capital. Other Methods of Estimating Cost of Equity Capital The EP Method r = EPS / Stock Price The Constant 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 big market, reflects tw o kinds of risk The risk of the profession itself The risk that the debt a business has will prevent cash flow to equity ?We can de-lever these equity betas to strip 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 rent a median of its industry peers asset betas (historically calculated) since one-time company events in the gone will be averaged out ? We can then find the equity beta for the company by re-levering the industry asset beta to the mark debt / cap ratio of the company ?Exhibit 4 provides various choices of comparable firms. Which firms do you recommend as the allow benchmarks for evaluating the risk of Ameritrades aforethought(ip) advertising and technology investments? Determine the betas for these firms. Let us agree that Charles Schwab is a comparable firm. Their price changes, dividends,and stock split information for 1992-1996 is in Exhibit 5. If there were no stock split, thereturn, compared to the previous 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 untold closer to 0. If there is an X for y stock split, use the recipe Copy the Return values into Exhibit 6 alongside 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 bandaging into the equation in 2 to estimate Ameritrades cost of capital