Cost of Capital at Ameritrade

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Harvard Business School 9-201-046
Rev. April 26, 2001
Professors Mark Mitchell and Erik Stafford prepared this case with the assistance of Research Associates Jose Camacho and
Aldo Sesia as the basis for class discussion rather than to illustrate either effective or ineffective handling of an
administrative situation.
Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission to
reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to
http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of Harvard Business School.
1
Cost of Capital at Ameritrade
In mid-1997, Joe Ricketts, Chairman and CEO of Ameritrade Holding Corporation, wanted to
improve his company’s competitive position in deep-discount brokerage1 by taking advantage of
emerging economies of scale. The success of the strategy required Ameritrade grow its customer
base. The growth would require substantial investments in technology to improve service and
capacity, and in advertising, to increase customer awareness. The strategy would require large
expenditures relative to Ameritrade’s existing capital. In order to evaluate whether the strategy
would generate sufficient future cash flows to merit the investment, Ricketts needed an estimate of
the project’s risk.
Company Background
Formed in 1971, Ameritrade has been a pioneer in the deep-discount brokerage sector. Not
only did Ameritrade help create the deep discount market, but it also was the first to offer many new
services that changed the way individual investors managed their portfolios. Ameritrade, for
example, was the first to offer automated touch-tone phone trading (1988), online internet trading2
(1994), a personal digital assistant to access trades (1995), and online program investing for individual
investors (1996).
The average return on equity during 1975 to 1996 was 40%, as all years, except two, posted a
positive return. Recent returns on equity were much higher, with each of the most recent five years
having larger returns than the 40% average.
In March 1997, Ameritrade (NASDAQ: AMTD) raised $22.5 million in an initial public
offering allowing the company to continue its long tradition of adopting the latest advances in
technology, and to substantially increase advertising to build its brand and improve market share.
1 Deep-discount brokers offer no-frills execution of equity and fixed income transactions for a minimal fee.
2 In 1995 Ameritrade acquired K. Aufhauser & Company which in 1994 launched the first internet trading site.
This document is authorized for use only in Prof. Samveg Patel's Corporate Finance / PGDM at Management Development Institute - Gurgaon from Jan 2023 to Apr 2023.
201-046 Cost of Capital at Ameritrade
2
Revenue Sources
Exhibit 1 displays Ameritrade’s income statement for the fiscal years 1995-1997 and Exhibit 2
presents the balance sheet for 1996 and 1997.
Ameritrade’s two primary sources of revenue were from transaction and net interest.
Transaction revenues consisted of brokerage commissions, clearing fees, and payment for order flow,
which were cash payments received by Ameritrade for routing orders to execution agents. Interest
revenues were generated by charging customers on debt balances maintained in brokerage accounts
and the investment of customers’ cash segregated in compliance with federal regulations in short-
term marketable securities. Interest revenues were offset by interest payments to customers based on
credit balances maintained in brokerage accounts.
Virtually all of Ameritrade’s revenues were directly linked to the stock market. Investors
generally curtailed trading activity and their borrowing in response to sustained downward
movements in the stock market. For example, trading activity declined more than 20% in 1988
following the stock market crash of October 19, 1987. A substantial decline in the stock market could
therefore lead to a steep decline in Ameritrade’s brokerage commissions and net interest revenues.
Full-service brokers were less sensitive to market movements than deep-discount brokers like
Ameritrade. Full-service brokers received asset management fees, which partially shielded the
revenue stream from market declines. Moreover, most full-service brokerage firms such as Merrill
Lynch diversified their revenue stream by engaging in investment banking activities such as mergers
and security underwritings.
Planned Investments and the Cost of Capital
Ricketts planned to grow Ameritrade’s revenues by targeting self-directed investors. Ricketts
decided Ameritrade’s mission was ‘to be the largest brokerage firm worldwide based on the number
of trades.’
Ricketts’ strategy called for price cutting, technology enhancements, and increased
advertising. First, Ameritrade would reduce commissions from $29.95 to $8.00 per trade for all
Internet market orders. There were currently no major players in this price range although many
customers were price sensitive. To ensure competitors such as Charles Schwab and E*Trade did not
follow Ameritrade’s lead and try to compete on price, Ameritrade would have to become the low cost
provider of reliable online brokerage services. State of the art technology was the only way to prevent
system outages and move towards the goal of 100% reliability. Therefore, up to $100 million would
be budgeted for technology enhancements which also would increase trade execution speed - an
important attribute to individual investors. Finally, Ameritrade’s advertising budget would be
increased to $155 million for the 1998 and 1999 fiscal years combined.
In order to gauge the financial impact of the advertising program and the investment in
physical plant and technology, there needed to be some accounting for the project’s risk. The plan
would only create value if the investment returned more than it cost. Surely the providers of capital
would demand a return that reflected the riskiness of the investment. Joe Ricketts strongly believed
that his role as CEO was to maximize shareholder value. If the expected returns on investment were
greater than the cost of capital, he was going to invest, even if there was a chance of bankrupting the
firm. Ricketts felt that the expected return on investment was very high, on the order of 30% to 50%.
But, he also knew that some members of his management team were not nearly as optimistic as he
was, estimating the expected investment returns at only 10% to 15%. But what was the cost of
capital?
This document is authorized for use only in Prof. Samveg Patel's Corporate Finance / PGDM at Management Development Institute - Gurgaon from Jan 2023 to Apr 2023.
Cost of Capital at Ameritrade 201-046
3
Recently, a CS First Boston analyst report employed a discount rate of 12% when evaluating
Ameritrade. The CFO at Ameritrade often used a 15% discount rate, while there were some
managers at Ameritrade who felt that the borrowing cost of 8-9% was the appropriate rate by which
to discount the future profit estimates. There was also the issue of the type of business that
Ameritrade was in. Was Ameritrade a discount brokerage firm or instead a technology/Internet
firm? A recent analyst report from ABN-AMRO valued Ameritrade on a comparables basis using
Internet firms such as Yahoo, Mecklermedia, and Netscape. In addition, E*Trade management
continued to insist that E*Trade, while deriving all of its revenues from brokerage operations, was
not a brokerage firm, and thus should not be valued as such.
Joe Ricketts hired a consultant to provide a cost of capital estimate that could be used in
evaluating Ameritrade’s upcoming investments. Exhibits 3-6 provide information that was
considered in estimating the cost of capital for Ameritrade.
This document is authorized for use only in Prof. Samveg Patel's Corporate Finance / PGDM at Management Development Institute - Gurgaon from Jan 2023 to Apr 2023.
201-046 Cost of Capital at Ameritrade
4
Exhibit 1 Consolidated Annual Income Statements for the Fiscal Year Ending in September
1997 1996 1995
Net Revenues
Transaction Income $ 51,936,902 $ 36,469,561 $ 23,977,481
Net Interest 18,193,946 11,477,878 8,434,584
Other 7,107,492 6,391,314 2,607,538
Total Net Revenues 77,238,340 54,338,753 35,019,603
Expenses Excluding Interest
Employee Compensation 19,290,808 14,049,642 8,481,977
Commissions and Clearance 3,320,262 2,530,642 2,516,796
Communications 5,623,468 3,685,535 2,352,590
Occupancy and Equipment Cost 5,422,839 2,889,654 1,626,725
Advertising and Promotion 13,970,834 7,537,265 4,842,392
Provision for Losses 59,000 148,014 1,428,663
Amortization of Goodwill 363,002 363,002 94,152
Other 7,763,014 4,717,406 2,846,280
Total Expenses Excluding Interest 55,813,227 35,921,160 24,189,575
Income Before Income Taxes 21,425,113 18,417,593 10,830,028
Taxes 7,602,964 7,259,248 3,798,881
Net Income $ 13,822,149 $ 11,158,345 $ 7,031,147
EPS $ 1.00 $ 0.87 $ 0.55
Shares Outstanding 13,768,889 12,813,823 12,813,823
Source: Ameritrade Annual Report, 1997.
This document is authorized for use only in Prof. Samveg Patel's Corporate Finance / PGDM at Management Development Institute - Gurgaon from Jan 2023 to Apr 2023.
Cost of Capital at Ameritrade 201-046
5
Exhibit 2 Consolidated Annual Balance Sheets for the Fiscal Year Ending in September
1997 1996
ASSETS
Cash & Cash Equivalents $ 53,522,447 $ 15,767,170
Cash & Investments Segregated in Compliance with Federal Regulations 319,763,921 175,668,497
Receivable from Brokers, Dealers, & Clearing Organizations 17,823,640 15,096,862
Receivable from Customers & Correspondents 325,407,147 166,075,055
Furniture, Equipment, & Leasehold Improvements 8,709,923 3,746,178
Goodwill 6,346,763 6,709,765
Equity Investments 7,597,972 7,157,783
Other Investments 5,000,000 5,000,000
Deferred Income Taxes 39,314 444,378
Other Assets 13,145,616 6,013,544
Total Assets $ 757,356,743 $ 401,679,232
LIABILITIES & STOCKHOLDER'S EQUITY
Liabilities:
Payable to Brokers, Dealers, & Clearing Organizations 1,404,999 1,193,479
Payable to Customers & Correspondents 666,279,440 356,942,970
Accounts Payable and Accrued Liabilities 19,252,931 7,221,008
Notes Payable to Bank - 4,853,000
Income Taxes Payable 3,430,279 806,711
Total Liabilities 690,367,649 371,017,168
Stockholder's Equity:
Class A Common Stock 131,534 114,494
Class B Common Stock 13,644 13,644
Additional Paid in Capital 23,297,506 809,665
Retained Earnings 43,546,410 29,724,261
Total Stockholder's Equity 66,989,094 30,662,064
Total Liabilities & Stockholder's Equity $ 757,356,743 $ 401,679,232
Source: Ameritrade Annual Report, 1997.
This document is authorized for use only in Prof. Samveg Patel's Corporate Finance / PGDM at Management Development Institute - Gurgaon from Jan 2023 to Apr 2023.
201-046 Cost of Capital at Ameritrade
6
Exhibit 3 Capital Market Return Data (Historical and Current)
Prevailing Yields on US Government Securities (August 31, 1997)
Annualized Yield to Maturity
3-Month T-Bills 5.24%
1-Year Bonds 5.59%
5-Year Bonds 6.22%
10-Year Bonds 6.34%
20-Year Bonds 6.69%
30-Year Bonds 6.61%
Historic Average Total Annual Returns on US Government Securities and Common Stocks (1950 – 1996)
Average Annual Return Standard Deviation
T-Bills 5.2% 3.0%
Intermediate Bondsa6.4% 6.6%
Long Term Bondsb6.0% 10.8%
Large Company Stocksc14.0% 16.8%
Small Company Stocksd17.8% 25.6%
Historic Average Total Annual Returns on US Government Securities and Common Stocks (1929 – 1996)
Average Annual Return Standard Deviation
T-Bills 3.8% 3.3%
Intermediate Bondsa5.4% 5.8%
Long Term Bondsb5.5% 9.2%
Large Company Stocksc12.7% 20.3%
Small Company Stocksd17.7% 34.1%
Source: Yields are from Datastream, historical data are from Ibbotson Associates, SBBI 2000 Yearbook.
aPortfolio of US Government bonds with maturity near 5 years.
bPortfolio of US Government bonds with maturity near 20 years.
cStandard and Poor’s 500 Stock Price Index.
dA subset of small cap stocks traded on the NYSE (1926-1981); Dimensional Fund Advisor’s Small Company Fund (1982-1997).
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201-046 -7-
Exhibit 4 Selected Data for Comparable Firms
Debt/Value Debt/Value
(Market Values) (Book Values) Brokerage
Firm Name (Industry) Current Avg 1992-1996 Current Avg 1992-1996 Revenues (%)
A G Edwards (Investment Services)a0.00 0.00 0.00 0.00 57
Bear Stearns (Investment Services) 0.60 0.50 0.69 0.60 35
Charles Schwab Corp (Discount Brokerage) 0.05 0.08 0.25 0.30 82
E*Trade (Discount Brokerage) 0.00 NA 0.00 NA 95
Lehman Brothers (Investment Services) 0.79 NA 0.80 0.79b13
Mecklermedia (Internet) 0.00 0.00b0.00 0.00b0
Merrill Lynch & Co (Investment Services) 0.57 0.52 0.77 0.65 37
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