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MCI Communications Corp.: Capital Structure Theory
I. Background of the Case
MCI Communications Corp., a long distance telecommunications company, had been performing rather slowly in a stable market, and the management sensed a growing restlessness on the part of shareholders.
To enhance the 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
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
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.