WACC Solution

1. (A)

The payback is 35,000/5,000= 7 years

Computation of the NPV :

15
NPV= -35,000 + 5,000 / ( 1 + 12%)^ 15
i=1

NPV = $- 947. 67

Computation of the IRR :

15
0= -35,000 + 5,000 / ( 1 + IRR)^ 15
i=1

IRR= 11.49%

The NPV of this project is negative and the IRR is lower than the Cost of Capital of 12%
so Rainbow products shouldnt go for this investment opportunity.

1. (B)
Based on the perpetuity formula we can calculate the present value:
Computation of the PV:
PV= Cash flow per year/ cost of capital
=4,500 / 0.12
= $37,500
Computation of the NPV:

NPV= -Initial investment + PV
= -35,000 + 37,500
NPV=$2,500
Rainbow products could buy this machine with the service contract as it has a positive
NPV of $2,500.


1.(C)

Computation of the PV :

PV= C/ k-g

In this case C (end of year perpetuity payout) = 5,000-1,000= $4,000 k= 12%, discount
rate
g= 4%, growing rate at perpetuity

PV= 4,000 / (0.12-0.04) = $50,000

Computation of the NPV :

NPV= -35,000+ 50,000 = $15,000

The rainbow products company should invest in this project because its NPV is largely
positive because of the reinvestment of 20% of the annual cost, even though this is in a
very long term vision..
Questions Covered
1. What factors should Ameritrade management consider when evaluating
the proposed advertising program and technology upgrades? Why?
2. How can the Capital Asset Pricing Model be used to estimate the cost
of capital for a real (not financial) investment decision?
3. What is the estimate of the risk-free rate that should be employed
in calculating the cost of capital for Ameritrade?
4. What is the estimate of the market risk premium that should be
employed in calculating the cost of capital at Ameritrade?
5. In principle, what are the steps for computing the asset beta in the
CAPM for the purposes of calculating the cost of capital for a project?
6. Ameritrade does not have a beta estimate because the firm has been
publicly traded for only a short time period. Exhibit 4 provides various
choices of comparable firms. What comparable firms do you
recommend as the appropriate benchmarks for evaluating the risk of
Ameritrades planned advertising and technology investments?
7. Using the stock price and returns data in Exhibits 4 and 5, and the
capital structure information in Exhibit 3, calculate the asset betas for
the comparable firms.
8. How should Joe Ricketts, the CEO of Ameritrade, view the cost of
capital you have calculated?


Dear Andy! Sorry for my second delay with the case it is all the preparation to
universityexams. I shall try to finish Friendly Cards in time.So I used to make parallels
from cases to our real life and economic situation in Ukraine. At thetime we do not
have such companies as Ameritrade in Ukraine, because this kind of businessdoes not
have its customers right now. This is a new thing to our country, and as usual, all
thenew things are taken distrustfully.I can recall only one example : it is FOREX, but it
actually deals with the currency exchangerates, buying and selling currency. The only
same thing all the processes are being held online.

1 . Wh a t f a c t o r s s h o u l d A me r i t r a d e c o n s i d e r wh e n e v a l u a t i n g
t h e p r o p o s e d a d v e r t i s i n g program and technology upgrades?Ameritrade
needs a cost of capital to evaluate new projects. Firms maximize their value by taking
all positive NPV projects.
( )
( )

+=
iii
r CF E NPV
*
1

...,2,1,0
=
i
( )
i
CF E
is the expected cash flow in period
i
*
r

is the discount rateTo calculate an NPV, we need a discount rate. In the A-Rod case we
used 8%. In theOcean Carriers case we used 9%. In this case we will learn how to
determine anappropriate rate.If Ameritrade analysts use a discount rate that is too high,
good projects may be rejected.If they use a discount rate that is too low, bad projects
may be accepted.Also the Ameritrade analysts should consider, that their companys
internal discount ratewas often used as 15%, but some managers felt appropriate the
rate of 8-9%. At this time,the external discount rate, used by Credit Swiss First Boston
was 12%.
Goodobservation.
So actually computing the NPV earlier, Ameritrade analysts accepted only the
best projects which fitted their high requirements.
Now at the end of your analysis, we seethat Ameritrade has a cost of capital close to 22%. This
high hurdle rate means thatAmeritrade should only accept projects with a very high potential
rate of return (aslong as they are of similar risk levels).
2 . Ho w c a n t h e Ca p i t a l A s s e t P r i c i n g Mo d e l ( CA P M) b e u s e d
t o e s t i ma t e t h e c o s t o f c a p i t a l for a real investment decision? (Note: A
real
investment decision here is contrastedfrom a
financial
investment decision. We are talking about real projects, with investmentin people and
technologies, etc.)