Case Study

Wagners Angels

Elisa Colaiacomo
Giulia Cova
Camilla Georgeon

1712264
1715846
1717776
1

Executive and facts summary:

Ameritrade, a US deep-discount brokerage firm formed in 1971, is an innovator in its sector: it was
the first to provide several services that modified the approach of individual investors with respect
to their portfolios. The company underwent an IPO in 1997 raising $22.5 million. The next natural
step to follow seemed the expansion of its competitive position in the industry. To reach this goal,
the company would need to cut prices, enhance technology and increase advertising. All these
things would obviously require great capital investments, namely $100m for technology
enhancements and $155m for advertising.

Statement of problem:
So as to decide whether to go for this strategy or not, the CEO Joe Ricketts had to evaluate the
riskiness of the project. This implied a number of issues. The NPV of such project could only be
evaluated after choosing the right discount rate (cost of capital) on which not everybody in and out
the firm agreed. Furthermore, as the company had just gone public through IPO, the historical data
on which calculations could be based was insufficient therefore only information on comparable
firms could be used. Which kind of firm is Ameritrade? Some regard it as an internet based firm,
whereas others as a discount brokerage one. This difference is fundamental in taking the right
decision.

Analysis:
According to the Capital Asset Pricing Model (CAPM), if the company has no debt outstanding,
the return on equity is to be computed as follows:
r = rf+ ( rm - rf )
So as to apply such formula, we need an estimate of the risk free rate rf and the risk premium (rm rf).

The risk free rate is usually associated to U.S. T-bills returns, which are very safe securities with a
=0. Taking into consideration that the strategy foreseen by the CEO is a long-term one, we would
suggest to observe the T-bills annual return in the last few decades before the IPO and in the IPO
year too. Data from Exhibit 1 shows that the average annual return of T-bills recorded from 1950 to
1996 amounted to 5.2% and the rate for 1997 was 5.24%. This is no surprise, since the standard
deviation for such returns is quite low (3%), we can therefore expect the risk free rate to be close to
this number in the next years.
On the other hand, the computation of the risk premium is quite troubling for Ameritrade. Typically
analysts use the stock market return minus U.S. government bond returns, that is precisely (rm-rf).
Unlike the bond market, where the current yields are the unbiased market prices for bonds whose
cash flows are in the future, we dont have a reliable estimate of where the stock market will move.
It all depends on our expectations about the future. Exhibit 1 shows the returns for large company
stocks both in the time interval (1950-1996) and in the antecedent interval (1929-1996). Now, if we
expect the next few years to follow the trend of the past four decades, then we should probably
apply rm = 14%. On the contrary, if we expect an inversion of trend, (noticing that the interval
1929-1956 comprises both financial crisis and war), we should then apply rm= 12.7%.
Furthermore, it has to be remarked that the standard deviation on stock returns in both periods is
particularly high, thus we need to keep in mind that past values are not to be used as strongly
reliable forecasts. All in all, we may apply an average of the stock returns for large companies in
both periods:
i.e: rm= (14%+12.7%)/2= 13.35 %
If so, then our risk premium is:
(rm - rf)= 13.35% - 5.2% = 8.15%
Now that we have estimated the risk free rate and the risk premium, the only value still lacking for
the computation of the companys return on equity through CAPM is the firms Beta. However,

since Ameritrade only went public recently, we do not have our own measure, hence we will have
to base our computations on an estimate taken from a comparable firm. At this point the CEO has
another difficult decision to make: what kind of business is AMERITRADE in? Some regard it as a
discount brokerage firm, whereas others think of it as an Internet based company.
We decide to consider Ameritrade as a discount brokerage firm, because virtually all its revenues
are directly linked to the stock market and therefore we take into consideration the Beta of similar
firms such as Charles Schwab Corp, Quick and Reilly Group and Waterhouse. We show the results
of our calculations in our second Exhibit, a series of scatter plots representing the Betas computed.
We think the best estimate for our companys Beta is an average of all the comparable firms Betas,
which is
= 1.973
Concluding, the companys return on equity we estimated is
r = rf + (rm - rf) = 5.2% + 1.973 x (8.15%) =21.28%
Now we should calculate the cost of capital, also known as WACC, to compare it with the expected
return.
We = 1 - Wd = 1 - (0.08 + 0.38) / 4 = 0.885
WACC = re x We = 18.83%
Recommendations:
The CEO Joe Rickett expected a return of 30-50%, whereas other company members regarded this
value as too optimistic: to them, a reasonable expected return for the project was around 10-15%.
As we found 18.33% of cost of capital, we can say that this investment may lead to the bankruptcy
of the firm if the pessimistic members are right. However if we make an average of the two
forecasts (26.25%) the strategy may prove to be successful. Therefore before investing, Joe should
review the specificities of the plan.

Exhibit 1

Capital Market Return Data (Historical and Current)

Prevailing Yields on U.S. Government

Securities (August 31, 1997)
Annualized Yield to Maturity
3-Month T-Bills
1-Year Bonds
5-Year Bonds
10-Year Bonds
20-Year Bonds
30-Year Bonds

5,24%
5,59%
6,22%
6,34%
6,69%
6,61%

Historic Average Total Annual Returns

on U.S. Government Securities and
Common Stocks (1950-1996)

T-Bills
a
Intermediate Bonds
b
Long-term Bonds
c
Large Company Stocks
d
Small Company Stocks

Average Annual Return

Standard Deviation

5,2%
6,4%
6,0%
14,0%
17,8%

3,0%
6,6%
10,8%
16,8%
25,6%

Average Annual Return

Standard Deviation

3,8%
5,4%
5,5%
12,7%
17,7%

3,3%
5,8%
9,2%
20,3%
34,1%

Historic Average Total Annual Returns

on U.S. Government Securities and
Common Stocks (1929-1996)

T-Bills
a
Intermediate Bonds
b
Long-term Bonds
c
Large Company Stocks
d
Small Company Stocks

Sources: Yields are from Datastream,

historical data are from Ibbotson
Associates, SBBI 2000 Yearbook.
a

Portfolio of U.S. Government bonds with

maturity near 5 years.
b
Portfolio of U.S. Government bonds with
maturity near 20 years.
c
Standard & Poor's 500 Stock Price Index.
d
A subset of small cap stocks traded on the
NYSE (1926-1981); Dimensional Fund
Advisor's Small Company Fund (19821997).

Exhibit 2 Scatter Plots : Comparable firms Betas

Beta = 2,337626441

Beta = 1,4024149

Beta = 2,180147518

Exhibit 3 : Formulas

Stock Returns

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If no splits

X for y stock splits

Beta
Slope function on excel, stock returns and VW NYSE, AMEX, and NASDAQ

WACC

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