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