MCI Communications, Corp: Capital Structure Theory
In Feburary 1996 the Board of Directors of MCI Communications wishes to correct
what they perceive to be an undervalued stock price through the implementation of a
stock repurchase program. As part of this plan, the Board must decide whether to
finance the repurchase by increasing MCI’s debt financing or to repurchase its
stock but only as corporate funds allow. The latter course of action would not call
for any increase in debt.
The company has requested the help of Lynch Investments in determining the
implications of going forward with the debt financing option. Students must
recommend which option makes the most sense for MCI. The considerations include
the board’s desire to signal the financial markets, the consequences of issuing $2
billion in debt on MCI’s price per share, and on the weighted average cost of capital
(WACC), and the implications for financial distress and flexibility. The objective of
this case is to calculate tax shields and estimating capital costs (WACC).
1. What message is MCI trying to send to financial markets?
2. Will the repurchase work to signal management’s view? What are the pros and
cons of each strategy?
3. What should MCI do? Take a vote, Sum up points
4. What will be the effect of issuing $2 billion of new debt and using the
proceeds to repurchase debt on:
a. MCI’s shares outstanding,
b. MCI’s book value of equity.
c. The price per share of MCI stock, and
d. Earnings per share.
5. Would book value and market value weights change as a result of the
repurchase?
6. What is MCI’s current WACC before the repurchase?
7. What will the new WACC be if the repurchase is undertaken?
8. So it’s a good deal? WACC falls and we can just go by the numbers? Is there
anything missing from estimates we used to calculate the WACC?
9. Would you recommend that MCI increase its use of debt? If so, by how much?
MCI Communication, corp.:
Capital structure theory
On a cold winter morning in February 1996, Katzu Mizuno stood admiring the
panoramic view of New York Harbor from the nineteenth floor of the World Trade
Center. In his first five months in New York as a first-year associate for Lynch
Investments, Katzu had been pleasantly surprised to have some free time to explore
the Big Apple. During this period, he had found an apartment, been to Madison
Square Garden for a Knicks game, attended the symphony at Lincoln Center, and had
made frequent trips to a Sushi bar in his neighborhood. The tranquility of the moment
ended, however, with an urgent phone call from his boss, Anna Curti.
Earlier that morning, MCI Communications, Corp., a long-time client of the firm, had
called seeking advice about establishing a program to repurchase some of its
outstanding common stock. As Exhibit 1 shows, throughout most of 1995 MCI’s
stock had been a sluggish performer in an otherwise buoyant market, and
management sensed a growing restlessness on the part of shareholders. At a recent
meeting of the board of directors, discussions had centered on repurchasing some of
company’s stock as a means to enhance shareholder value. One longtime director,
Gavin Philips, pushed hard to finance the repurchase by increasing MCI’s debt
financing. He argued that this action would send a bold signal to the market about the
future prospects of the firm. To be effective as a signal, Philips suggested that the
company would need to increase its debt-equity ratio from its current level around 40
percent to ‘more or less twice that.’ He said, “Even at that debt level, MCI’s debt-to-
cap would be moderate relative to the industry.” He estimated that such action would
require MCI to issue approximately $2 billion in additional debt. Other directors,
concerned that the increased debt burden might impede the company’s current capital-
expansion program, argued for a less extreme approach. They favored an open-market
purchase program instead. Under this option, the company would announce its
intentions to repurchase its stock from “ time to time” but only as corporate funds
allowed. This course of action, therefore, did not call for any increase in debt.
