Ameritrade – case study
Ameritrade provides online brokerage services and operates an Internet-based financial management services business. 90% of the company’s revenues are from the provision of discount brokerage services.
The company’s objective is to improve its competitive position in deep-discount brokerage. In order to achieve this objective, the company must grow its customer base, requiring an investment of $100 million to upgrade its technological capabilities as well as an increase of $155 million for its advertisement budget. In order to evaluate the company’s cost of capital, we used the Cost Asset Pricing Model. Since the company went public ...view middle of the document...
It is necessary to consider current as well as future potential strategies adopted by Ameritrade’s key competitors and determine what impact these strategies may have on Ameritrade. The market for discount brokerage services, particularly electronic brokerage services is a new rapidly evolving and intensely competitive market with few barriers to entry. Ameritrade encounters direct competition from approximately 100 other discount brokerage firms, many of which provide electronic brokerage services. These competitors include discount brokerage firms such as Charles Schwab & Co., Inc., Fidelity Brokerage Services, Inc., National Discount Brokers Group, Inc., Quick & Reilly, Inc., and E*Trade Group, Inc. Ameritrade has seen increased competition since 1997 and expects this to continue and intensify in the future. It is expected that Ameritrade’s competitors will also adopt strategies of price-cutting, similar to those proposed by Ameritrade.
Ameritrade, as a result of operating in the discount brokerage market, is currently impacted by significant trends that may affect its financial conditions and thus the results of its operations. Commissions charged to customers of discount brokerage services have steadily decreased over the past several years, and this is expected to continue. This has had a negative impact on Ameritrade’s per trade commission and clearing fee revenue but has resulted in increased account activity and an overall increase in commission and clearing fee revenue. The development of technology and increased use of electronic mediums is expected to decrease operating expenses per trade.
Since Ameritrade’s revenues are derived from the securities brokerage business, they may be directly affected by economic and political conditions as well as changes in volume and price levels of securities transactions. An economic downturn adversely affects the firm’s trading volumes and subsequently its net revenues, negatively affecting profitability. It is therefore advised that the company engage in marketing efforts to grow its customer base during favorable economic conditions when marketing efforts will be better received by the public.
Estimating the Cost of Capital
In order to calculate the cost of capital of Ameritrade we will use the Capital Asset Pricing Model. This model helps estimate the required rate of return of a certain investment for the given risk. In the case of Ameritrade, we can use this method by finding the most accurate risk free rate, market risk premium and asset beta. We can then find the return on assets by using the following formula:
Ra= Rf+ βa (Rm-Rf)
To find the asset Beta (βa), we need to find the weighted average β of equity and the weighted average β of debt. We consider the β of debt to be 0, as debt has no relationship with market risk and it is evident from the balance sheet that Ameritrade had no interest bearing debt in 1997.