Ameritrade Case
Rickets believes hat the investment carries a lot of risk that requiring a more in-depth financial justification as opposed to Marinade’s existing financial policy. Through initial discussions with Mr.. Rickets, we have agreed upon a financial analysis, adopting the CAMP model, to calculate the cost of capital of the investment. Mr.. Rickets & his management team will then make a sound financial decision basing on our analysis results. According to our agreed plans, Mr.. Rickets has specifically requested us to perform the following three tasks and provide our recommendation accordingly. . Briefly discuss the asset beta and CAMP model, and explain the steps for computing the asset beta and CAMP to produce the cost of capital for the Investment project.
II. Mr.. Rickets is aware that Marinated does not have a beta estimate due to short trading history, and demands us to hand pick comparable firms that will be valuable In assessing the risk of Marinade’s planned Investment.
Ill. Using the supplied financial data to calculate the asset betas for the comparable firms. L. Definition of Asset beta.
Beta represents a measure of the volatility, or systematic risk, of a security or a oratorio in comparison to the market as a whole. It is also known as “beta coefficient”. And Is calculated using regression analysis. It represents the tendency of a security’s returns to respond to swings in the market. Beta can be calculated by dividing the covariance between the return on the asset and the return on the market and the variance of the market This relationship is represented by the following formula: Levered versus unleavened Beta.
Unleavened Beta compares the risk of an unleavened company to the risk of the market. The unleavened beta Is the beta of a company without any debt. Enlivening a beta removes the financial effects from leverage. The formula to calculate a company’s unleavened beta is: This number provides a measure of how much systematic risk a firm’s equity has when compared to the market. Enlivening the beta removes any beneficial effects gained by adding debt to the firm’s capital structure.
Comparing companies’ unleavened betas gives an Investor a better Idea of how much risk they will be taking on when purchasing a firms’ stock. Levered Beta, on the contrary, represents market risk of the investment taking into consideration market risk of the debt. Definition of CAMP (Capital Asset Pricing Model) CAMP is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The cost of equity is approximated Premium). Definition of the cost of capital.
The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WAC).
Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project. Steps in calculating Beta for Marinated: With the above explanation, the cost of capital for Marinated is, calculated by the CAMP model, will be using the three major steps:
- Determine the Ref (risk-free rate) hat best reflects the marke
- Determine the Asset Beta for Marinated
- Determine RMI (market-return rate).
We will decide on the Ref and RMI with the supplied return data (Historical and current). On the other hand, we will diligently pick the best comparable firms, and then calculate the covariance between the past returns on the comparable firms and the return on market portfolio. Lastly, we produce a beta estimate by dividing the covariance (previously calculated) by the variance of the market. Market stock returns for indices such as NYSE, AMES and Nasdaq, which present the weighed average of all US publicly traded firms, are available in Exhibit 6 of the case.
The returns are presented for the time period of 1984 to 1997. Returns on comparable firms in the Investment Services industry are also presented in the same exhibit. It is important to point out that the firms presented are full-service brokerage firms and are less sensitive to market movements than Marinated due to the fact that deep-discount brokers such as Marinated do not engage in asset management and investment banking services like full-service brokers do. Marinade’s revenue stream is fully dependent on its brokerage operations.
Given the above, we suggest to calculate covariance between each one of the four investment services firms presented and the market as a whole represented by the indices provided. Next step is to divide each of the results from step one by the market variance calculated based on the indices presented in Exhibit
In essence, we have calculated Betas for each of the four comparable firms. Then we would calculate an average of the four betas to use as an estimated Beta for Marinated. However, as motioned above, Marinated has a more volatile business model than full service investment firms.
Therefore, we need to increase the resulting Beta by some estimated factor in order to be able to represent corresponding market risk more accurately.
II. In determining the appropriate comparable for Marinated, we ran into a challenge of finding a direct comparison in both operating risk and capital structure risk. In this analysis, we are making the assumption that Marinated will need to take on some debt in order to fund the additional investments in to technology and marketing squired.
We decided to look at three types of companies for as potential comps for Brothers, Merrill Lynch, etc. )
Discount Brokerage Firms (e. G. Charles Schwab, E*Trade, Quick & Reilly Group, etc. )
Internet Companies (e. G. Macromedia, Netscape, Yahoo) Operationally the full service brokers don’t share the same level of risk as Marinated. Marinade’s business is very sensitive to the performance of the stock market since almost all of their revenue is generated through brokerage. During a market decline, investors tend to decrease investing activities, thus Marinade’s venue suffers.
The full service brokers have less sensitivity to the overall market because the also offer other services, such as asset management and investment banking. The higher operating risk associated with discount brokerage firms, including Marinated, would lead to higher betas in comparison to the full service brokers. In comparing the capital structure of the other discount brokerage firms, Marinated will have more risk (requiring a high Beta) since they will be carrying debt (other than Charles Schwab (. 25) Debt-to-Capital, none of the other discount brokerages carry debt).
We do feel that Marinade’s competitive advantage over the other discount brokerage firms comes through technology (more specifically reliable internet based transactions), so using other internet based companies as comps makes sense. But, like the other discount brokerage firms, the other internet comps carry no debt, so the financial risk is going to be lower in comparison to Marinated. In order to determine the best comps, we decided to take a mull-faceted approach. For one, we determine the statistical significance (analysis is later on in this report) of each of the betas to eliminate some of the comps.
Through that analysis, we determined that E*Trade, Macromedia, and Netscape did not have enough history to be statistically significant. To further narrow the list, we also determined that Charles Schwab Corp. and Waterholes Investor Services were the most comparable firms since they both are discount brokerage firms with a very significant percentage of revenue and coming from brokerage (99% for Charles Schwab and 82% for Waterholes) and they also both have debt (currently Waterholes has no debt but has historically) in their capital structure. As far as full service brokers, we felt Raymond James Financial and Paine Webber were good comps. Both firms had a large percentage of revenue coming from brokerage (51% for Raymond James and 46% for Paine Webber) and both firms carry some debt (especially Paine Webber) in their capital structure. We also decided to throw in Yahoo as a comps since Marinated is largely an internet based company. In the end, we determine an average of Charles Schwab Corp., Waterholes Investor Services, and Yahoo made the best beta estimate. Ill. An important component of analyzing Marinade’s cost of capital is to use the betas of comparable firms.
