Cost of Capital at Ameritrade

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.

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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.

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201-046 Cost of Capital at Ameritrade

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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?

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Cost of Capital at Ameritrade 201-046

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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.

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201-046 Cost of Capital at Ameritrade

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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.

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Cost of Capital at Ameritrade 201-046

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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.

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201-046 Cost of Capital at Ameritrade

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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