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This problem set is due by 9:00 a.m. on Wednesday, 11/28. No late assignments will be accepted.
Questions: Assume that the investments under consideration will be ï¬nanced with equity only (i.e., no debt ï¬nancing).
1. What estimate of the risk-free rate should be employed in calculating the cost of capital for Ameritrade?
2. What estimate of the market risk premium should be employed in calculating the cost of capital for Ameritrade?
3. Ameritrade does not have a beta estimate since the ï¬rm has been publicly traded for only a short time period. Exhibit 4 provides various choices of comparable ï¬rms. What comparable ï¬rms do you recommend as the appropriate benchmarks for evaluating the risk of Ameritrades planned advertising and technology investments? Hints for #3:
¢ It does not matter what Ameritrade spends its investments on up-front (advertising and technology investments) since these costs are known numbers, and you are calculating the cost of capital to ï¬gure out the present value of the projected cash ï¬‚ows from later years. What matters is what beta the ï¬rms assets will have, where the assets are the subsequent cash ï¬‚ows that Ameritrade gets out of making the up-front investments.
¢ It is probably not useful to use a comparable that has very little data (less than 2 years, say) since the equity beta you estimate based on very little data will be very noisy (you can try it”look at the standard error on your estimated equity beta).
Hints for #4:
Î²E : To estimate the equity betas, here are some hints:
¢ Please regress (raw) stock returns on (raw) market returns”you are not given a time series for the riskless rate, so you cannot run the regression using excess stock returns and excess market returns (over the riskless rate).
¢ You use the market returns from Exhibit 6, but youll have to discuss with your group members whether you should use value-weighted or equal-weighted market returns. (The equal-weighted market return sets all the xi s to be equal.) ¢ For some of the stocks you are given data for stock prices and dividends rather than being given the stock return directly. Some of the stocks have undergone stock splits.