Case Study Case Study Harvard Business School 9-201-046 Rev. April 26, 2001 Professors Mark Mitchell and Erik Stafford prepared this case with the assista

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Case Study Case Study Harvard Business School 9-201-046
Rev. April 26, 2001

Professors Mark Mitchell and Erik Stafford prepared this case with the assistance of Research Associates Jose Camacho and
Aldo Sesia as the basis for class discussion rather than to illustrate either effective or ineffective handling of an
administrative situation.

Copyright © 2000 by the President and Fellows of Harvard College. To order copies or request permission to
reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to
http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of Harvard Business School.

1

Cost of Capital at Ameritrade

In mid-1997, Joe Ricketts, Chairman and CEO of Ameritrade Holding Corporation, wanted to
improve his company’s competitive position in deep-discount brokerage1 by taking advantage of
emerging economies of scale. The success of the strategy required Ameritrade grow its customer
base. The growth would require substantial investments in technology to improve service and
capacity, and in advertising, to increase customer awareness. The strategy would require large
expenditures relative to Ameritrade’s existing capital. In order to evaluate whether the strategy
would generate sufficient future cash flows to merit the investment, Ricketts needed an estimate of
the project’s risk.

Company Background

Formed in 1971, Ameritrade has been a pioneer in the deep-discount brokerage sector. Not
only did Ameritrade help create the deep discount market, but it also was the first to offer many new
services that changed the way individual investors managed their portfolios. Ameritrade, for
example, was the first to offer automated touch-tone phone trading (1988), online internet trading2
(1994), a personal digital assistant to access trades (1995), and online program investing for individual
investors (1996).

The average return on equity during 1975 to 1996 was 40%, as all years, except two, posted a
positive return. Recent returns on equity were much higher, with each of the most recent five years
having larger returns than the 40% average.

In March 1997, Ameritrade (NASDAQ: AMTD) raised $22.5 million in an initial public
offering allowing the company to continue its long tradition of adopting the latest advances in
technology, and to substantially increase advertising to build its brand and improve market share.

1 Deep-discount brokers offer no-frills execution of equity and fixed income transactions for a minimal fee.
2 In 1995 Ameritrade acquired K. Aufhauser & Company which in 1994 launched the first internet trading site.

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201-046 Cost of Capital at Ameritrade

2

Revenue Sources

Exhibit 1 displays Ameritrade’s income statement for the fiscal years 1995-1997 and Exhibit 2
presents the balance sheet for 1996 and 1997.

Ameritrade’s two primary sources of revenue were from transaction and net interest.
Transaction revenues consisted of brokerage commissions, clearing fees, and payment for order flow,
which were cash payments received by Ameritrade for routing orders to execution agents. Interest
revenues were generated by charging customers on debt balances maintained in brokerage accounts
and the investment of customers’ cash segregated in compliance with federal regulations in short-
term marketable securities. Interest revenues were offset by interest payments to customers based on
credit balances maintained in brokerage accounts.

Virtually all of Ameritrade’s revenues were directly linked to the stock market. Investors
generally curtailed trading activity and their borrowing in response to sustained downward
movements in the stock market. For example, trading activity declined more than 20% in 1988
following the stock market crash of October 19, 1987. A substantial decline in the stock market could
therefore lead to a steep decline in Ameritrade’s brokerage commissions and net interest revenues.

Full-service brokers were less sensitive to market movements than deep-discount brokers like
Ameritrade. Full-service brokers received asset management fees, which partially shielded the
revenue stream from market declines. Moreover, most full-service brokerage firms such as Merrill
Lynch diversified their revenue stream by engaging in investment banking activities such as mergers
and security underwritings.

Planned Investments and the Cost of Capital

Ricketts planned to grow Ameritrade’s revenues by targeting self-directed investors. Ricketts
decided Ameritrade’s mission was ‘to be the largest brokerage firm worldwide based on the number
of trades.’

Ricketts’ strategy called for price cutting, technology enhancements, and increased
advertising. First, Ameritrade would reduce commissions from $29.95 to $8.00 per trade for all
Internet market orders. There were currently no major players in this price range although many
customers were price sensitive. To ensure competitors such as Charles Schwab and E*Trade did not
follow Ameritrade’s lead and try to compete on price, Ameritrade would have to become the low cost
provider of reliable online brokerage services. State of the art technology was the only way to prevent
system outages and move towards the goal of 100% reliability. Therefore, up to $100 million would
be budgeted for technology enhancements which also would increase trade execution speed – an
important attribute to individual investors. Finally, Ameritrade’s advertising budget would be
increased to $155 million for the 1998 and 1999 fiscal years combined.

In order to gauge the financial impact of the advertising program and the investment in
physical plant and technology, there needed to be some accounting for the project’s risk. The plan
would only create value if the investment returned more than it cost. Surely the providers of capital
would demand a return that reflected the riskiness of the investment. Joe Ricketts strongly believed
that his role as CEO was to maximize shareholder value. If the expected returns on investment were
greater than the cost of capital, he was going to invest, even if there was a chance of bankrupting the
firm. Ricketts felt that the expected return on investment was very high, on the order of 30% to 50%.
But, he also knew that some members of his management team were not nearly as optimistic as he
was, estimating the expected investment returns at only 10% to 15%. But what was the cost of
capital?

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Cost of Capital at Ameritrade 201-046

3

Recently, a CS First Boston analyst report employed a discount rate of 12% when evaluating
Ameritrade. The CFO at Ameritrade often used a 15% discount rate, while there were some
managers at Ameritrade who felt that the borrowing cost of 8-9% was the appropriate rate by which
to discount the future profit estimates. There was also the issue of the type of business that
Ameritrade was in. Was Ameritrade a discount brokerage firm or instead a technology/Internet
firm? A recent analyst report from ABN-AMRO valued Ameritrade on a comparables basis using
Internet firms such as Yahoo, Mecklermedia, and Netscape. In addition, E*Trade management
continued to insist that E*Trade, while deriving all of its revenues from brokerage operations, was
not a brokerage firm, and thus should not be valued as such.

Joe Ricketts hired a consultant to provide a cost of capital estimate that could be used in
evaluating Ameritrade’s upcoming investments. Exhibits 3-6 provide information that was
considered in estimating the cost of capital for Ameritrade.

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201-046 Cost of Capital at Ameritrade

4

Exhibit 1 Consolidated Annual Income Statements for the Fiscal Year Ending in September

1997 1996 1995

Net Revenues

Transaction Income $ 51,936,902 $ 36,469,561 $ 23,977,481

Net Interest 18,193,946 11,477,878 8,434,584

Other 7,107,492 6,391,314 2,607,538

Total Net Revenues 77,238,340 54,338,753 35,019,603

Expenses Excluding Interest

Employee Compensation 19,290,808 14,049,642 8,481,977

Commissions and Clearance 3,320,262 2,530,642 2,516,796

Communications 5,623,468 3,685,535 2,352,590

Occupancy and Equipment Cost 5,422,839 2,889,654 1,626,725

Advertising and Promotion 13,970,834 7,537,265 4,842,392

Provision for Losses 59,000 148,014 1,428,663

Amortization of Goodwill 363,002 363,002 94,152

Other 7,763,014 4,717,406 2,846,280

Total Expenses Excluding Interest 55,813,227 35,921,160 24,189,575

Income Before Income Taxes 21,425,113 18,417,593 10,830,028

Taxes 7,602,964 7,259,248 3,798,881

Net Income $ 13,822,149 $ 11,158,345 $ 7,031,147

EPS $ 1.00 $ 0.87 $ 0.55

Shares Outstanding 13,768,889 12,813,823 12,813,823

Source: Ameritrade Annual Report, 1997.

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Cost of Capital at Ameritrade 201-046

5

Exhibit 2 Consolidated Annual Balance Sheets for the Fiscal Year Ending in September

1997 1996

ASSETS

Cash & Cash Equivalents $ 53,522,447 $ 15,767,170

Cash & Investments Segregated in Compliance with Federal Regulations 319,763,921 175,668,497

Receivable from Brokers, Dealers, & Clearing Organizations 17,823,640 15,096,862

Receivable from Customers & Correspondents 325,407,147 166,075,055

Furniture, Equipment, & Leasehold Improvements 8,709,923 3,746,178

Goodwill 6,346,763 6,709,765

Equity Investments 7,597,972 7,157,783

Other Investments 5,000,000 5,000,000

Deferred Income Taxes 39,314 444,378

Other Assets 13,145,616 6,013,544

Total Assets $ 757,356,743 $ 401,679,232

LIABILITIES & STOCKHOLDER’S EQUITY

Liabilities:

Payable to Brokers, Dealers, & Clearing Organizations 1,404,999 1,193,479

Payable to Customers & Correspondents 666,279,440 356,942,970

Accounts Payable and Accrued Liabilities 19,252,931 7,221,008

Notes Payable to Bank – 4,853,000

Income Taxes Payable 3,430,279 806,711

Total Liabilities 690,367,649 371,017,168

Stockholder’s Equity:

Class A Common Stock 131,534 114,494

Class B Common Stock 13,644 13,644

Additional Paid in Capital 23,297,506 809,665

Retained Earnings 43,546,410 29,724,261

Total Stockholder’s Equity 66,989,094 30,662,064

Total Liabilities & Stockholder’s Equity $ 757,356,743 $ 401,679,232

Source: Ameritrade Annual Report, 1997.

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201-046 Cost of Capital at Ameritrade

6

Exhibit 3 Capital Market Return Data (Historical and Current)

Prevailing Yields on US Government Securities (August 31, 1997)

Annualized Yield to Maturity

3-Month T-Bills 5.24%

1-Year Bonds 5.59%

5-Year Bonds 6.22%

10-Year Bonds 6.34%

20-Year Bonds 6.69%

30-Year Bonds 6.61%

Historic Average Total Annual Returns on US Government Securities and Common Stocks (1950 – 1996)

Average Annual Return Standard Deviation

T-Bills 5.2% 3.0%

Intermediate Bondsa 6.4% 6.6%

Long Term Bondsb 6.0% 10.8%

Large Company Stocksc 14.0% 16.8%

Small Company Stocksd 17.8% 25.6%

Historic Average Total Annual Returns on US Government Securities and Common Stocks (1929 – 1996)

Average Annual Return Standard Deviation

T-Bills 3.8% 3.3%

Intermediate Bondsa 5.4% 5.8%

Long Term Bondsb 5.5% 9.2%

Large Company Stocksc 12.7% 20.3%

Small Company Stocksd 17.7% 34.1%

Source: Yields are from Datastream, historical data are from Ibbotson Associates, SBBI 2000 Yearbook.
aPortfolio of US Government bonds with maturity near 5 years.
bPortfolio of US Government bonds with maturity near 20 years.
cStandard and Poor’s 500 Stock Price Index.
dA subset of small cap stocks traded on the NYSE (1926-1981); Dimensional Fund Advisor’s Small Company Fund (1982-1997).

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201-046 Cost of Capital at Ameritrade

8

Exhibit 5 Stock Price Data for Discount Brokers

Ameritrade

Date Shares Price Dividend Stock Split

31-Mar-97 13,153 15.625 –

30-Apr-97 13,153 12.500 –

30-May-97 13,153 14.000 –

30-Jun-97 14,518 15.750 –

31-Jul-97 14,518 15.375 –

29-Aug-97 14,518 18.813 –

Charles Schwab

Date Shares Price Dividend Stock Split

30-Sep-87 29,121 15.875 –

30-Oct-87 29,121 7.875 –

30-Nov-87 29,121 6.625 –

31-Dec-87 25,388 6.000 –

29-Jan-88 25,388 6.500 –

29-Feb-88 25,388 9.000 –

31-Mar-88 25,388 7.375 –

29-Apr-88 25,388 7.625 –

31-May-88 25,388 6.875 –

30-Jun-88 25,294 7.250 –

29-Jul-88 25,294 7.500 –

31-Aug-88 25,294 6.750 –

30-Sep-88 25,328 6.750 –

31-Oct-88 25,328 7.500 –

30-Nov-88 25,328 6.750 –

30-Dec-88 25,354 6.750 –

31-Jan-89 25,354 10.250 –

28-Feb-89 25,354 8.625 –

31-Mar-89 25,354 8.875 –

28-Apr-89 25,354 10.125 –

31-May-89 25,354 11.750 0.030

30-Jun-89 25,352 11.000 –

31-Jul-89 25,352 16.500 0.030

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Cost of Capital at Ameritrade 201-046

9

31-Aug-89 25,352 15.750 –

29-Sep-89 25,386 14.000 –

31-Oct-89 25,386 13.000 0.030

30-Nov-89 25,386 12.500 –

29-Dec-89 25,332 13.875 –

31-Jan-90 25,332 13.500 0.030

28-Feb-90 25,332 15.250 –

30-Mar-90 25,332 17.000 –

30-Apr-90 25,332 15.125 0.030

31-May-90 25,332 15.750 –

29-Jun-90 25,099 15.250 –

31-Jul-90 25,099 13.625 0.030

31-Aug-90 25,099 12.625 –

28-Sep-90 25,255 11.375 –

31-Oct-90 25,255 12.625 0.040

30-Nov-90 25,255 11.875 –

31-Dec-90 24,464 11.375 –

31-Jan-91 24,464 16.000 0.040

28-Feb-91 24,464 18.250 –

28-Mar-91 24,464 20.250 –

30-Apr-91 24,464 18.125 0.040

31-May-91 24,464 22.500 –

28-Jun-91 24,435 24.750 –

31-Jul-91 24,435 27.500 0.050

30-Aug-91 24,435 28.375 –

30-Sep-91 25,596 31.125 –

31-Oct-91 25,596 37.750 0.060

29-Nov-91 25,596 32.750 –

31-Dec-91 38,394 30.375 – 3 for 2

31-Jan-92 38,394 31.875 0.040

28-Feb-92 38,394 33.250 –

31-Mar-92 38,479 34.625 –

30-Apr-92 38,479 28.500 0.060

29-May-92 38,479 28.875 –

30-Jun-92 38,626 23.500 –

31-Jul-92 38,626 24.625 0.060

31-Aug-92 38,626 22.500 –

30-Sep-92 38,149 18.000 –

30-Oct-92 38,149 20.250 0.060

30-Nov-92 38,149 24.875 –

31-Dec-92 37,741 26.125 –

29-Jan-93 37,741 30.250 0.060

26-Feb-93 37,741 32.375 –

31-Mar-93 37,741 36.500 –

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201-046 Cost of Capital at Ameritrade

10

30-Apr-93 37,741 32.750 0.075

28-May-93 37,741 35.250 –

30-Jun-93 56,612 28.500 – 3 for 2

30-Jul-93 56,612 29.000 0.050

31-Aug-93 56,612 32.875 –

30-Sep-93 57,625 34.500 –

29-Oct-93 57,625 34.625 0.050

30-Nov-93 57,815 31.875 –

31-Dec-93 57,815 32.375 –

31-Jan-94 57,815 29.500 0.070

28-Feb-94 57,815 27.500 –

31-Mar-94 57,815 26.875 –

29-Apr-94 57,815 28.375 0.070

31-May-94 57,815 30.250 –

30-Jun-94 57,114 24.750 –

29-Jul-94 57,114 26.750 0.070

31-Aug-94 57,114 30.750 –

30-Sep-94 56,829 29.625 –

31-Oct-94 56,829 35.375 0.070

30-Nov-94 57,325 31.875 –

30-Dec-94 57,325 34.875 –

31-Jan-95 57,325 40.000 0.090

28-Feb-95 57,325 44.375 –

31-Mar-95 85,988 32.250 – 3 for 2

28-Apr-95 85,988 34.250 0.060

31-May-95 85,988 35.000 –

30-Jun-95 85,896 43.875 –

31-Jul-95 85,896 46.125 0.080

31-Aug-95 87,061 46.625 –

29-Sep-95 174,122 29.000 – 2 for 1

31-Oct-95 174,122 22.875 0.040

30-Nov-95 174,678 24.250 –

29-Dec-95 174,678 20.125 –

31-Jan-96 174,678 25.125 0.040

29-Feb-96 174,678 25.500 –

29-Mar-96 174,678 25.875 –

30-Apr-96 174,032 24.500 0.040

31-May-96 174,032 24.250 –

28-Jun-96 174,989 24.500 –

31-Jul-96 174,989 24.125 0.050

30-Aug-96 174,989 25.000 –

30-Sep-96 175,166 23.000 –

31-Oct-96 175,166 25.000 0.050

29-Nov-96 175,166 30.250 –

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Cost of Capital at Ameritrade 201-046

11

31-Dec-96 175,173 32.000 –

31-Jan-97 175,173 37.500 –

28-Feb-97 175,173 37.500 0.050

31-Mar-97 175,173 32.000 –

30-Apr-97 175,068 36.625 –

30-May-97 175,068 40.625 0.050

30-Jun-97 175,813 40.500 –

31-Jul-97 176,422 47.000 –

29-Aug-97 176,422 42.750 0.050

E*Trade

Date Shares Price Dividend Stock Split

30-Aug-96 29,393 10.500 –

30-Sep-96 29,539 13.188 –

31-Oct-96 29,539 11.125 –

29-Nov-96 29,539 10.938 –

31-Dec-96 29,545 11.500 –

31-Jan-97 29,545 17.625 –

28-Feb-97 29,545 24.000 –

31-Mar-97 30,440 18.000 –

30-Apr-97 30,440 15.000 –

30-May-97 30,440 17.625 –

30-Jun-97 30,958 19.625 –

31-Jul-97 30,958 30.500 –

29-Aug-97 30,958 32.125 –

Quick & Reilly

Date Shares Price Dividend Stock Split

31-Jan-84 6,318 17.625 –

29-Feb-84 6,318 15.000 0.050

30-Mar-84 6,318 14.875 –

30-Apr-84 6,318 17.125 –

31-May-84 6,318 17.375 –

29-Jun-84 6,318 18.000 0.050

31-Jul-84 6,318 14.750 –

31-Aug-84 6,318 18.000 0.050

This document is authorized for use only by Monica Maize (mrsmaize1@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org
or 800-988-0886 for additional copies.

201-046 Cost of Capital at Ameritrade

12

28-Sep-84 6,318 17.000 –

31-Oct-84 6,318 17.875 –

30-Nov-84 6,318 15.250 0.050

31-Dec-84 6,318 15.500 –

31-Jan-85 6,318 23.375 –

28-Feb-85 6,318 23.750 0.110

29-Mar-85 6,318 23.125 –

30-Apr-85 6,318 20.625 –

31-May-85 6,318 22.625 0.060

28-Jun-85 6,318 24.000 –

31-Jul-85 6,318 24.125 –

30-Aug-85 6,318 22.875 0.060

30-Sep-85 6,318 20.125 –

31-Oct-85 6,318 22.250 –

29-Nov-85 6,318 25.500 0.060

31-Dec-85 6,318 32.500 –

31-Jan-86 6,318 36.375 –

28-Feb-86 6,318 39.125 0.170

31-Mar-86 6,318 39.000 –

30-Apr-86 6,318 30.375 –

30-May-86 11,149 33.375 0.070

30-Jun-86 11,149 35.500 –

31-Jul-86 11,149 29.000 –

29-Aug-86 11,149 28.750 0.070

30-Sep-86 11,149 23.875 –

31-Oct-86 11,149 32.125 –

28-Nov-86 11,149 29.500 0.070

31-Dec-86 11,149 26.750 –

30-Jan-87 11,149 36.125 –

27-Feb-87 11,149 36.875 0.200

31-Mar-87 11,149 36.000 –

30-Apr-87 16,724 21.375 – 3 for 2

29-May-87 16,724 21.500 0.055

30-Jun-87 9,477 19.250 –

31-Jul-87 9,477 20.250 –

31-Aug-87 9,477 24.625 0.055

30-Sep-87 9,477 23.000 –

30-Oct-87 9,477 12.125 –

30-Nov-87 9,477 11.625 0.055

31-Dec-87 9,477 12.500 –

29-Jan-88 9,477 12.625 –

29-Feb-88 9,477 13.500 0.180

31-Mar-88 9,452 12.250 –

29-Apr-88 9,452 12.625 –

This document is authorized for use only by Monica Maize (mrsmaize1@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org
or 800-988-0886 for additional copies.

Cost of Capital at Ameritrade 201-046

13

31-May-88 9,452 11.500 0.060

30-Jun-88 9,452 11.875 –

29-Jul-88 9,452 11.500 –

31-Aug-88 9,452 11.250 0.060

30-Sep-88 9,452 11.750 –

31-Oct-88 9,452 11.750 –

30-Nov-88 9,452 11.500 0.060

30-Dec-88 9,452 10.875 –

31-Jan-89 9,452 15.000 –

28-Feb-89 9,452 13.750 0.060

31-Mar-89 9,452 13.250 –

28-Apr-89 9,452 13.000 –

31-May-89 9,452 16.125 0.060

30-Jun-89 9,452 14.000 –

31-Jul-89 9,452 16.500 –

31-Aug-89 9,452 17.000 0.060

29-Sep-89 9,452 16.750 –

31-Oct-89 9,452 15.750 –

30-Nov-89 9,452 14.875 0.060

29-Dec-89 9,452 13.625 –

31-Jan-90 9,452 12.000 –

28-Feb-90 9,452 13.625 0.130

30-Mar-90 9,452 13.250 –

30-Apr-90 9,452 13.000 –

31-May-90 9,452 15.250 0.070

29-Jun-90 9,452 14.000 –

31-Jul-90 9,452 13.500 –

31-Aug-90 9,452 11.375 0.070

28-Sep-90 9,452 10.375 –

31-Oct-90 9,452 9.750 –

30-Nov-90 9,452 10.125 0.070

31-Dec-90 9,437 10.250 –

31-Jan-91 9,437 13.125 –

28-Feb-91 9,437 16.125 0.070

28-Mar-91 9,210 18.875 –

30-Apr-91 9,210 17.500 –

31-May-91 9,210 17.750 0.070

28-Jun-91 9,452 17.000 –

31-Jul-91 9,452 19.625 –

30-Aug-91 9,452 20.625 0.070

30-Sep-91 9,210 19.250 –

31-Oct-91 9,210 20.375 –

29-Nov-91 9,210 20.000 0.070

31-Dec-91 9,220 27.750 –

This document is authorized for use only by Monica Maize (mrsmaize1@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org
or 800-988-0886 for additional copies.

201-046 Cost of Capital at Ameritrade

14

31-Jan-92 9,220 27.500 –

28-Feb-92 9,220 28.500 0.180

31-Mar-92 9,292 28.625 –

30-Apr-92 9,292 21.500 –

29-May-92 9,292 21.500 0.080

30-Jun-92 9,292 21.000 –

31-Jul-92 9,292 20.125 –

31-Aug-92 9,292 19.625 0.080

30-Sep-92 9,884 20.125 –

30-Oct-92 9,884 21.000 –

30-Nov-92 9,884 25.375 0.080

31-Dec-92 9,884 24.750 –

29-Jan-93 9,884 27.000 –

26-Feb-93 9,884 26.000 0.220

31-Mar-93 9,824 27.125 –

30-Apr-93 9,824 25.125 –

28-May-93 9,824 26.125 0.100

30-Jun-93 10,315 28.875 1.443

30-Jul-93 10,623 30.750 –

31-Aug-93 10,623 35.000 0.100

30-Sep-93 10,643 36.250 –

29-Oct-93 10,643 35.875 –

30-Nov-93 10,678 34.250 0.100

31-Dec-93 11,212 35.750 1.788

31-Jan-94 10,678 35.375 –

28-Feb-94 …

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