ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

MCI Communications Corp.: Capital Structure Theory

Updated on May 20, 2019
lee custodio profile image

Lee is a freelance researcher and writer for six years. She is currently pursuing her Master's degree in Management

I. Background of the Case

MCI Communications Corp. is a long distance telecommunications company that had been performing rather slowly in a stable market. The management sensed a growing restlessness among its shareholders and wanted to do something about it by regaining the shareholder's confidence in the company.

To enhance shareholders’ value, the company planned to repurchase some of its outstanding common stock. By announcing a share buyback program, the board is hoping to convey to the market that the stock is undervalued because (1) a share buyback at the current price may represent a positive NPV that is potentially greater than the other uses of funds; and (2) the repurchase is simply a way to increase the firm’s debt. Either way, both will have a positive effect on the share price.

To guide the management in its decision, the company sought the advice of Lynch Investments in establishing a program to repurchase some of its outstanding common stocks. This leads to Katzu Mizuno, an associate of Lynch Investments, to investigate what source of fund is appropriate for the repurchase program and the possible effect of such action in the company.

II. Effects of issuing $2B in Additional Debt

Assuming that MCI declares a repurchase of $2 billion of its stocks, the value of the firm will increase after the announcement and would not change on the repurchasing date. That is, the increase of the value will occur on the announcement date as oppose to the repurchasing date. The increase in value would also reflect the value of the tax shield.

If MCI did not repurchased its shares at one time, then the shares outstanding will be between 608.93 and 611.84 million as the repurchase price increases from its current $27.75 to $28.92.

Gavin Philips, MCI Director, suggested the company needs to increase its debt to equity ratio from the current 36 percent to “more or less twice that.” Even by doubling the debt-equity ratio, Philips insisted, “even at that debt level, MCI’s debt-to-cap would be moderate relative to the industry.”

III. Enhancing Shareholder Value Through Repurchase Of MCI Stocks

By increasing debt-equity ratio from 36 percent to 72 percent, MCI will be less flexible financially. However, since D/E ration would still be “moderate relative to the industry,” MCI’s rating won’t go below a medium grade of BBB. Based on data in Exhibit 2, MCI needs to unlevered and then re-lever the target company’s equity beta. Unlevering the equity beta of the company yields an estimated beta at par to the major competitors, which have different debt structure.

Thus, re-levering equity beta to reflect MCI’s target capital structure yields the appropriate risk for MCI to use in estimating a cost of capital if ever the issuance of additional $ 2 billion debt is pursued.

CAPM in 4 Easy Steps

Unlevering and Re-levering

Comparing the unlevered beta of MCI to the other major players in the industry, the company is relatively riskier than the competitors. As a result, the issuance of additional $ 2B debt would further increase the level of risk of MCI, as reflected in the new WACC:

Alternative 1: Debt Additional debt Equity

Weight 0.23 0.13 0.64

Cost (%) 6.1 6.161 7.22

After-tax Cost 3.66 3.696 7.22

WACC (after) 6.244%

Alternative 2: Debt Equity

Weight 0.26 0.74

Cost (%) 6.1 7

After-tax Cost 3.66 7

WACC 6.132%

Expected EPS will increase from $ 1.75 to $ 1.83 if the company will pursue the issuance of additional debt. Hence, higher returns will be a positive signal to the shareholders.

Before Issuance of Add’l $ 2B debt Expected

EPS = 1.75

No. of outstanding shares = 681M

Net Income = (1.75) (681) = $ 1,191.75M

Interest expense = (3, 444) (.061) = $ 210.084M

EBIT = 1,191.75 M + 0.6(210.084 M) 0.6 = $ 2,196.334M

After Issuance of Additional $2B debt

Expected EPS = 1.83

No. of outstanding shares = 608.928M

Net Income = (2,196.334 - 335.35) (0.6) = $1,116.59M

Interest expense = (5, 444)(.0616) = $335.35M

EBIT = 1,191.75 M + 0.6(210.084 M) 0.6 = $ 2,196.334 M

Even if MCI will finance the repurchase program through debt issuance, the company would still have a good bond rating. Finally, the value of the firm will increase from $ 22,367 M to $ 23,167 M.

Value of MCI after the issuance of add’l $ 2 billion debt

V = value of equity (MV) + value of debt

= $ 18,923 + $ 3,444 VU

value of unlevered firm = $ 22,367

VTB = $ 2,000 * 40% = $ 800

VL = VU + VTB

= $ 22,367 + $ 800

value of levered firm= $ 23,167

IV. Conclusion

MCI should repurchase its outstanding common stock through issuance of additional $ 2 billion debt. Though the company would be less financially flexible, the company can still easily obtain external funds to fund other projects or investments. Since new WACC increase, MCI’s risk level will also increase. But with higher risk comes higher return as well and this is reflected in the expected EPS after the issuance of additional debt. This issuance of additional debt will favor the company since this will contribute to the objective of maximizing shareholders value. Lastly, the value of the firm will be maximized if they will pursue the aggressive debt policy.

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://hubpages.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)
    ClickscoThis is a data management platform studying reader behavior (Privacy Policy)