Ameritrade Essay

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1. You have been given data for stock prices and dividends. Some of the stocks have undergone stock splits. To calculate returns when there is no stock split use r_t=(P_t-P_(t-1)+D_t)/P_(t-1) where P_t is the price at time t and Dt is the dividend. When there is an x for y stock split then you should calculate returns as r_t=(〖x/y P〗_t-P_(t-1)+〖x/y D〗_t)/P_(t-1) For example, in the case of a 5 for 4 stock split x/y=1.25. 2. You do not have data on debt returns for the comparable companies. A common rule of thumb that is used in practice is to assume that the debt of these companies is risk free (has a beta of zero). This is a good assumption when debt represents a fairly small fraction of the firm’s value. Questions: 1. How can the Capital Asset Pricing Model be used to estimate the cost of capital for a project (as opposed to a financial asset)? In particular, how can we apply the CAPM to estimate the cost of capital when we do not even know how the investment in the project will be financed (debt vs. equity)? (Here you think in terms of the risk of the project, or project beta, or asset beta). 2. What estimate of the risk-free rate should be employed in calculating the cost of capital for Ameritrade? (Hint: What is the duration of the project – long-term or short-term?) 3. What estimate of the market risk premium should be employed in calculating the cost of capital for Ameritrade? 4. Ameritrade does not have a beta estimate since the firm has been publicly traded for only a short time period. Exhibit 4 provides various choices of comparable firms. What comparable firms do you recommend as the appropriate benchmarks for evaluating the risk of Ameritrade’s planned advertising and technology investments? 5. Using the data provided in the case, calculate the asset betas for the companies that are appropriate comparables for Ameritrade. 6. What is your

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