Mci Communications Corp
It seemed that the board of directors at MCI was divided between two possible solutions. Should the company finance the repurchase by increasing MCI’s debt financing by at least doubling the current debt-equity ration that stood at 36% at that time (MCI)? Conversely, would a more conservative approach of using an open-market purchase program, announcing its intentions to repurchase its stock from “time to time” but only as corporate funds become available, be more appropriate (MCI)? The answer to this question will help determine the path that the company will follow in the years to come.
It will also either instill confidence or continue the growing sense of restlessness that is currently being exhibited by the company’s shareholders. Therefore, in an effort to determine the most advantageous path for MCI, we will focus on answering the following three questions given in the course module to meet our objectives. 1) What would be the effects of issuing $2 billion of new debt and using the proceeds to repurchase shares of the following: a) the book value of MCI’s equity b) the price per share of MCI’s stock; and c) the earnings per share of MCI’s stock.
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) What is the current WACC for MCI and what would it become after the new debt and repurchase? 3) Would you recommend this new debt and repurchase of stock alternative to the MCI Board of Directors? Explain your answer. The first questions asks us what would be the effects of issuing $2 billion of new debt and using the proceeds to repurchase shares of the book value of MCI’s equity, the price per share of MCI’s stock, and the earnings per share of MCI’s stock.
Referring to the chart below, we realize that by accruing debt re-capitalization by issuing a $2 billion debt to purchase $2 billion stock will not affect the firm’s cash flow. Based on the assumption of earning before the interest income remains the same, we have determined that the cost of debt will increased by $123 millions due to the interest accrued by the new debt. We get EBT by subtract the interest expenses from EBIT. Then we subtract the tax expenses from EBT will lead us to the new net income, $498 Million.
The $2 billion debt divided by the current market price per share will result in a shares buy back of 72 million shares. Furthermore, the outstanding shares should be using the original outstanding shares minus the buy back shares. New EPS equals the new net income divided by the new shares outstanding. The new Long-term debt increase from $3,444 million to $5,444 million and therefore, the new book value of equity is $ 9,602 Million minus $2 billion. Based on these computations, MCI’s new book value is $7,602 million.
Equity holders will receive a higher expected rate of return after the re-capitalization, but will bear a higher level of risk per dollar invested, for which the higher expected rate of return precisely compensates them. By increasing debt, decreasing equity for $2 billion, MCI’s EPS decreased 1 cents per share from $0. 83 per share to $ 0. 82 per share. However, the Price per share increased to $ 32. 31, PE ratio, and ROE are increased as well. (chart) The second question asks us to compute MCI’s current WACC and what would it become after the new debt and repurchase.
The first thing we need to do is determine MCI’s existing WACC. The following formula is used: (formula) Given the following, provided in the case study, one is left to derive VL and rS: (chart) The CAPM provides the following means to derive rS: (chart) Based on these computations, MCI’s new book value is $7,602 million. Equity holders will receive a higher expected rate of return after the re-capitalization, but will bear a higher level of risk per dollar invested, for which the higher expected rate of return precisely compensates them.
To select the best option for MCI, we first need a clear separation between MCI’s equity and debt. MCI is a leveraged firm and taxation influences the value of this firm. The last question asks whether we would recommend this new debt and repurchase of stock alternative to the MCI Board of Directors. Naturally, we will support our recommendation with data generated from the first two questions above. We recommend the board at MCI to issue the additional $2 billion in debt and to apply the capital to repurchase MCI stock based on MCI’s current Weighted Average Cost of Capital (WACC) is 0. 362.
We realize that by adding the additional $2 billion in debt, their WACC decreased to 0. 356. We realize that this is not a significant drop in the cost of capital; however, it is a decrease in cost. The next thing that we need to focus on is how the additional debt and repurchasing of stock effects the companies stock ratios. Since one of MCI’s stated goals is to increase share holders value, we want to find out if the change in capital structure help the overall stock value? The answer can be found in question one. According to calculations, we determined that the PE Ratio increased from 33% to 40%.
In addition, the price per share increased with this additional debt from $27. 75 to $32. 31. Lastly the ROE also increased from 5. 97% to 6. 55%. The only negative change determined was, the decrease in earning per share from $0. 83 to $0. 82. Again, we note the insignificant change with the earnings per share value; however we do keep in mind that the value did in fact decrease. Overall, the stock ratios that were evaluated with this additional debt improved. Based on the ratios given, we conclude that change in MCI’s capital structure would add to the shareholder value.
Lastly, we examined the effects of the tax shield that this debt would generate. With our current tax laws, there is a tax advantage for a company to be leveraged. Our tax structure allows a maximum tax rate in which at a certain point, the amount of debt generated does not grant additional tax shield. MCI has yet to hit their maximum tax rate and therefore, can still benefit from the tax advantages. The present value of the tax shield for MCI was calculated at $776 million while the interest expense on this new debt is $304 million.
These numbers show that today’s tax advantage dollars is more than double the cost of interest on this new debt. All of this data supports our recommendation to the board of directors that it would be beneficial for MCI to issue the 2 billion in debt in order to repurchase the company stock. The issuance of new debt and repurchasing of company owned stock looks to be the safest hedge against an insecure future/economy and stiffening competition from start ups and less debt-laden companies.
The data, from the stock ratios down through the final WACC computations tend to quantifiably support our recommendations for the MCI Board. Couple this with the tax shelter benefits that are still currently below their cap, this growing telecommunications force should weather the late 90’s storm and produce better than average dividends and earning estimates to maintain its stock prices and therefore its foothold in this lucrative and burgeoning field.