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 riskfree rate of return, market risk premium (the rate above the historical riskfree
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 riskfree 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” riskfree return.
3.
What is the riskfree rate that should be used in calculating the cost of capital using the CAPM?
Explain.
The riskfree rate should match the project horizon of the potential investment.
The Ameritrade
case mentions nearterm investments are being considered, including enhancements in
technology and a twoyear advertising budget.
The case also mentions that Ameritrade has a
“long tradition of adopting the latest advances in technology.”
Due to the twoyear 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 riskfree rate
should reflect the anticipated fiveyear bond yield of 6.22%.
The 10, 20 or 30year bonds are
too long based on how rapidly things develop in the technology field, and the 3month 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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What is the estimate of riskpremium 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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 Summer '08
 MURPHY
 Capital Asset Pricing Model, Ameritrade, comparable firms

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