Case Study
mrsaiz
CaseStudy-Simplified.pptx1
BA 519
A Case Study of
Ameritrade
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BACKGROUND INFORMATION
It is September of 1997 now, and you are working for Ameritrade. You are now responsible to estimate the required return for a capital budgeting decision.
However, since Ameritrade had its IPO only six months ago, in March 1997, there is no sufficient stock price and return information available for your analysis.
Therefore, you have to identify a comparable firm and use its cost of capital to evaluate the new project.
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After examining the major players in the same industry, you have identified the firm that resembles Ameritrade the most, while having sufficient (5 yrs.) price and return data for the analysis: Charles Schwab.
Now you have downloaded the stock split, dividend, and stock price information of Charles Schwab in addition to the return information of value-weighted returns of the overall NYSE, AMEX, and NASDAQ stocks.
The above information is provided in the Excel file. Please use “Sheet1” of the Excel file to find the information.
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WHAT YOU NEED TO DO TO FIND THE REQUIRED RETURN?
Since none of the estimation models is perfect, while each model has different issues, the common approach is to use multiple models to estimate the cost of capital for the firm, Charles Schwab.
We will be using 3 models to estimate the cost of equity:
CAPM
Market Model
1 of the 3 Dividend Models
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CAPM
According to CAPM, the cost of equity is calculated as
Looking at the right-hand side of CAPM equation…
RF rate
βi =
=>Holding Period Return =
RM = The average return of the market portfolio (RM) is proxied by the simple average annual return of the “VW NYSE, AMEX, and NASDAQ”.
Since the company had several stock splits in the past 5 yrs, we need to first adjust for stock splits before we can calculate the monthly returns and Beta for CS.
What is stock split?
i.e. 2-for-1 split vs 3-for-2 split
What is the purpose of stock split?
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MARKET MODEL
To make sure that you are confident with your cost of equity estimate, you will also use Market Model to estimate the cost of equity.
RA or E(R) =
Regression analysis will be used to find the α and β
outputs, before cost of equity can be calculated.
βA =
Note that the β in the Market Model is different from the β in CAPM.
Dividend Model
We discussed 3 dividend models in earlier chapter(s)
(1) Zero Growth or Constant Dividend?
(2) Constant Growth?
(3) Variable Growth?
Which of the 3 dividend models should be used to estimate the cost of equity in this case?
To decide which dividend model is appropriate, we will first graph our annual dividends
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Are the 3 cost of equity estimates similar? If they are similar, you should be quite confident with your cost of equity estimate. If one of them is very different from the rest, drop it and find reasons to justify for your decision.
The common approach is to keep only the similar estimates and use the simple average of the similar r estimates as your cost of equity for the weight average cost of capital for the firm (WACC).
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WACC
The Weighted Average Cost of Capital is given as RWACC :
WE X RE + WD X RD X (1-T)
WE = capital structure weight for equity = proportion of the company assets financed through equity = .
WD= capital structure weight for debt= proportion of the company assets financed through debt = .
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If the Wall St. Journal shows that the cost of debt of the comparable firm is 6.2%, find the WACC of the comparable firm and use it as the WACC for the capital budgeting decision, assuming 35% marginal tax rate.
Since M&M propositions state that the cost of equity and cost of debt are specific to the firm’s capital structure. Therefore, if we are using cost of equity of CS, ideally, we should also use the cost of debt and capital structure of CS when estimating WACC.
Use Exhibit 4 to find the capital structure weights for CS when calculating the WACC.
Should you use book value or market value to find the capital structure weights?
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