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Ellie Johnson, Erica Tsai, Juan Carlos De La Guardia, and Tareq Mouasher

Professor Cornaggia
Applied Financial Management (FINC 212)
3 February 2016

1. Regression for Competitors Equity Betas


Charles Schwab 2.2983:

Quick & Reilly 2.2056:

Waterhouse Investor Services 3.1875

2. Unlevered Equity Betas


Note the market values for the average capital structure between 1992-1996 was used.

3. Ameritrade Levered Beta

4. Ameritrade Weighted Average Cost of Capital (WACC) using CAPM

The data from the table was obtained from these sources:
Cost of Debt: Page 3, first paragraph of case
Risk-Free Rate: Exhibit 3: Intermediate Bonds Average Annual Return (1950 - 1996)
Market Risk Premium: Exhibit 3: Large Company Stock Average Annual Return (1950 - 1996) Intermediate Bonds Average Annual Return (1950-1996)

5. Cost of Capital Recommendation


After calculations, it is recommended that Ameritrade use a cost of capital of 23.9816% when
discounting projects with similar risk levels to that of the overall firms. To arrive at this number,
a regression analysis of the returns of three comparable companies, Charles Schwab, Quick &
Reilly, and Waterhouse Investors, on market returns was conducted to determine the respective
betas of each company. Each beta was then unlevered according to the 1992-1996 average
market value capital structure for each firm (presented in Exhibit 4) to find the equity beta. The
market value was used rather than the book value because the market value better reflects the
current economic value of debt and equity outstanding. The average value is used as well
because the current capital structure may not be the target capital structure. A firms target capital
structure is what optimizes the companys stock price and minimizes a companys WACC,
therefore an average better reflects a movement towards this target capital structure. After
finding the equity betas for Charles Schwab, Quick & Reilly, and Waterhouse Investors, the three

equity betas were averaged to find an industry average equity beta. This was then re-levered
according to Ameritrades capital structure to find Ameritrades beta. Looking at Ameritrades
balance sheet (Exhibit 2), it appears that Ameritrade does not have any long term debt
obligations. Based on the definition that the debt component of a companys capitalization
simply takes into account their long term debt, we made the assumption that Ameritrades capital
structure was 100% equity. Thus, the average equity beta, 2.3134, can be substituted in as
Ameritrades beta in the capital asset pricing model (CAPM) to find Ameritrades cost of equity,
23.9816%. Since Ameritrades capital structure is 100% equity, its cost of debt is 0%; thus,
Ameritrades cost of equity of 23.9816% is equal to its weighted average cost of capital.

When using the CAPM we decided to use the historic average annual return between 1950-1996
of Intermediate Bonds, a portfolio of US Government bonds with maturity near 5 years, as our
risk free rate of return of 6.4%. We picked this return for several reasons. To begin, the returns of
the companies used to calculate beta were between 1992 and 1996, which is encompassed in the
average annual returns for the time period of 1950-1996. Secondly, the five-year index was
picked because it was the most accurate match to the longevity of Ameritrades project. The
project, being mostly about technology advancements, would not last longer than 5 years to
implement therefore making the 6.4% risk free rate accurate. Additionally, the 3 or 6-month
Treasury bill would not allot for the project to be completed on time while the 10-year treasury
bond is too much time since the technology industry is ever changing. When calculating the
market risk premium (MRP) for the CAPM model, the 6.4% risk free rate of return (Rm) was
kept consistent. To match the time frame of the risk free rate of return (Rm) of an average
between 1950-1996, the large company stocks, or Standard and Poors 500 Stock Price Index,
average annual return of 14.0% was used as the expected market return (Rm). Subsequently, our
market risk premium (MRP) was calculated to be 7.6% (14%-6.4% = 7.6%). After substituting
the risk free rate of return (Rm), Ameritrades beta, and the market risk premium (MRP) into the
CAPM model, we arrived at a WACC of 23.9816%.

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