Ameritrade_Case30 - 1. What factors should Ameritrade...

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1. What factors should Ameritrade management consider when evaluating the proposed advertising program and technology upgrades? Why? Ameritrade should consider: Net Present Value (NPV) of the investment in technology and advertising as well as the Internal Rate of Return (IRR) and Opportunity Cost of Capital. These measurements will take into consideration assumptions about project risks and market return which will help to determine if the investment in technology and advertising will reap as great a return as if the stockholders were paid out the value of the anticipated investment and invested it on their own elsewhere. 2. How can the Capital Asset Pricing Model (CAPM) be used to estimate the cost of capital for real (not financial) investment decision? CAPM uses risk-free rate of return, market risk premium (the rate above the historical risk-free rate that will attract investors to a risky investment) and the investment’s beta (relative risk of an investment compared to other risky assets). Based on the inputs into the formula, it would not matter what the investment is under consideration. The CAPM takes the premium over the risk- free rate that would entice someone to invest in something else and multiples that by the specific risk associated with the potential investment/project. The product of these two amounts is then added to the estimated future risk-free rate. The total equals the potential return on an investment or project. Regardless of what is being invested, the formula helps to determine if the potential return is greater than the “safe” risk-free return. 3. What is the risk-free rate that should be used in calculating the cost of capital using the CAPM? Explain. The risk-free rate should match the project horizon of the potential investment. The Ameritrade case mentions near-term investments are being considered, including enhancements in technology and a two-year advertising budget. The case also mentions that Ameritrade has a “long tradition of adopting the latest advances in technology.” Due to the two-year advertising budget proposal and Ameritrade’s practice of investing in the latest technology (which would not have a prolonged useful life), the time horizon to determine the cost of capital for these investments is closer to five years. Therefore, the risk-free rate should reflect the anticipated five-year bond yield of 6.22%. The 10-, 20- or 30-year bonds are too long based on how rapidly things develop in the technology field, and the 3-month and 1- year bonds are not long enough to reflect the length of the investment (which will be at least two years based on the advertising budget being considered).
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4. What is the estimate of risk-premium on the market that should be used in the CAPM? Explain. The estimated risk premium to be used in the CAPM should be the excess of the market portfolio
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This note was uploaded on 03/07/2012 for the course REE 6930 taught by Professor Murphy during the Summer '08 term at University of Florida.

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Ameritrade_Case30 - 1. What factors should Ameritrade...

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