Finance Ameritrade Is About to Essay

2. The capital asset pricing model can be used to estimate the cost of capital because it allows for an estimate to be drawn as to the company's cost of equity. This can then be plugged into a weighted average cost of capital calculation along with the company's debt and, if relevant, preferred shares. The cost of equity reflects the company's risk in relation to the risk associated with the market in general. Investors will want the returns of the company to be commensurate with the risk that they are taking on, in order to justify that investment.

The capital asset pricing model is as follows:

Ra = Rf + ?(Rm-Rf)

That weighted average cost of capital is the discount rate that should be used to discount the expected future cash flows of the project to determine whether or not the project adds value to the firm.

3. The risk free rate is the rate of return that one would earn without taking on risk. The only securities that have no risk are short-term government securities.There is no hard-and-fast rule about which Treasury rate should be used, but anything from three months to a year is reasonable. Longer-term bonds are not appropriate because there is risk associated with longer-term securities, even Treasuries, hence why they pay more. The current rate should always be used, rather than the historic rate, because the rate should reflect the opportunity cost of an investment decision today. The yield to maturity on a 1-year bond is 5.59%.

4. The market risk premium has two options in the case, one for large company stocks and one for small company stocks. The characteristics of each of these types of companies determines which one is more appropriate. Given that Ameritrade is newly public, growing rapidly and the book value of the company's equity at $67 million, Ameritrade would fit more into the small company category. As such, the market risk would 12.7%.

From this, the risk free rate must be….....