Study Questions for MCI Communications (#30)

Note that the case is self-contained.

References:
You must read Cases 28 and 29 to be able to do the MCI case.
Materials on capital structure policy in any standard textbook
Excel file for the case

1. What message is MCI trying to send to financial markets?

2. What will be the effect of issuing $2 billion of new debt and using the proceeds to
repurchase shares?

Price per share of MCI stock

Post-repurchase equity value = pre-repurchase equity value + PV (interest tax shield) –
PV (financial distress costs) ± signal value of private information
Post-repurchase per share value = pre-repurchase per share value + [PV of interest tax
shield)]/(number of shares o/s) – [PV (financial distress costs)]/(number of shares o/s) ±
[signal value of private information)]/(number of shares o/s)

If we ignore other effects but the tax effect, then the post leveraged recapitalization share
value=

MCI’s shares outstanding

If we adjust the current stock price only for our estimate of tax benefits, the repurchase
price would be $28.92.
Number of shares that will be repurchased =
Number of shares o/s after the stock repurchase =
Note, however, if MCI repurchases the stock at 27.75 a share, then the number of shares
remaining after the repurchase=

MCI’s pre-leveraged recapitalization book value of equity

Assets Liabilities and Equity
19,301 CL 4,870
LTD 3,444
Deferred taxes and 1,385
others
Shareholders’ equity 9,602

MCI’s post-leveraged recapitalization book value of equity

Assets Liabilities and Equity
CL
LTD
Deferred taxes and
others
Shareholders’ equity
Debt equity ratio
Before repurchase
Approximate value of debt = 3,444
Approximate value of equity = (27.75)(681) = 18,898 = 16,898
Approximate debt-equity ratio = (3,444/18,898) = 18%

After repurchase
Approximate value of debt =
Approximate value of equity =
Approximate debt-equity ratio =

Market-to-book ratio
Before repurchase
Book value per share = ($9602)/681 = $14.10
Market-to-book ratio of equity = $27.75/$14.10 = 1.97

After repurchase
Book value per share =
Market-to-book ratio of equity =

Earnings per share.

Before repurchase
EPS=($573)/681=$0.84
After repurchase
EPS=

3. What is MCI’s current weighted average cost of capital (WACC)?

Before the repurchase
Cost of equity = 5.7+ 1.0(7)=12.7%
WACC= (0.15)(6.1)(1-0.4)+(0.85)(12.7)=11.3%

4. What would you expect to happen to MCI’s WACC if it issues $2 billion in debt and
uses the proceeds to repurchased shares?
After the repurchase
Assume that target debt-to-equity ratio = 32%
Target weight of debt = 24%
Target weight of equity = 76%

Using the equation for the beta of levered equity:

Beta of levered equity = Asset beta [1+(1-Marginal tax rate)(Debt/Equity)]
Then,
Asset beta = Beta of levered equity/[1+(1-Marginal tax rate)(Debt/Equity)]
Therefore,
Asset beta of MCI = 1/[1 + (1-0.4)(0.15/0.85)]=0.90
After the leveraged recapitalization,
Relevered beta =
Cost of equity =

Given the increase in D/E, debt rating is assumed to go below A1, but above BBB1 and
the pre-tax cost of debt is assumed to increase from 6.1% to 6.4% (See Exhibit 3.)
Then,
WACC=

Do this analysis using the industry average asset beta. To get the industry average asset
beta, we must calculate individual firms’ asset betas.
Carry out a sensitivity analysis using different assumptions on the input parameters.

5. Would you recommend that MCI increase its use of debt? If so, by how much?
(i) In order to determine the minimum amount of EBIT required for the leveraged
recapitalization to have a positive effect on the EPS, we have to compute the indifference
EBIT using the indifference EBIT formula.

Indifference EBIT:
(EBIT-I1)(1-T)/N1 = (EBIT-I2)(1-T)/N2

Indifference EBIT=

At 1220, EPS before repurchase =

EPS after repurchase =

(ii) Carry out a FRICTO analysis.

FRICTO stands for flexibility, risk, income, control, timing, and other.
Make a table using FRICTO factors considering the status quo, the proposed leveraged
recapitalization, and other approaches.