Andy Eko

Eka Taruna

Satam

Tegun Kamilius

Prayogi Purnapandhega

Company Profile

• MCI Communications Corp. was an American telecommunications company that was instrumental in legal and regulatory changes that led to the breakup of the AT&T monopoly of American telephony and ushered in the competitive long-distance telephone industry. It was headquartered in Washington, D.C.

• Founded in 1963, it grew to be the second-largest long-distance provider in the U.S. It was purchased by WorldCom in 1998 and became MCI WorldCom, with the name afterwards being shortened to WorldCom in 2000. WorldCom's financial scandals and bankruptcy led that company to change its name in 2003 to MCI Inc.. The MCI name disappeared in January 2006 after the company was bought by Verizon.

Overview

• Most of 1995, MCI's stock had been a sluggish performer which is growing restlssness on the part of shareholder

• So, MCI communication corporation had called seeking advice about establishing a program to repurchase some of its outstanding common stock

1. What message is MCI trying to send financial markets?• In 1995, the performance of MCI’s stock is sluggis

h, and shareholder may grow restlessness, the board is concerned about the sub-par performance creating restlessness among shareholders. By announcing a share buyback program, the board is hoping to convey to the markets that the stock undervalued.•Repurchase some of outstanding common stock will enhance shareholder value

•if so, it required MCI to issue approximately $ 2 billion in additional debt which indicate that the company has been aggressive in financing its growth with debt.

2. What will be the effects of issuing $2 billion of new debt and using the proceeds

to repurchase shares on?

A. MCI’s shares outstanding.o   If we assume shares can be repurchased at $28.92, then 69.16 million shares can be repurchased back, leaving 611.84 million shares outstanding.o   IF we assume the shares can be repurchased at the current price of $27.75, then 72.07 million shares can be repurchased and leaves 608.93 million shares outstanding.o   If we assume the shares are not repurchased at one time, then shares outstanding are between 608.93 and 611.84 million as the repurchase price increases from $27.75 to $28.92

B. MCI’s book balue of equityo   Solution-1• Total Current Liabilities = 4870• Long – Term Debt = 3444+2000=5444• Deferred Taxes and Other = 1385• Stockholder’s Equity = 9602-2000=7602

Repurchase effect on leverage (use D/E ratio as a measurement, and assume that D refers to long-term debt):•Pre  D/E = 3444/9602 = 0.359•Post D/E = 5444/7602 = 0.716

“Philips suggested that the company would need to increase its debt-equity ratio from its current level of around 36 % to ‘at least twice that’, he said. ‘Even at that debt level, MCI’s debt-to-cap would be moderate relative to the industry’.”

C. Price per share of MCI stock  Assumption 1 – Market Capitalization Share Outstanding• If the company declares a repurchase of 2 billion, the val

ue of the firm will increase to reflect the value of the tax shield.

• As we assume the capital market is efficient, the value of the firm will increase immediately after the declaration, and will not change any more on the repurchase date.

• That is, the increase of the value occurs on the declaration date as against the repurchasing date.

• Post repurchase share price = pre repurchase price + PV of interest tax saving = $27.75+(0.4x2000)/681=$28.92Or, post repurchase share price = (Current market capitalization + Value of tax shield)/681 = $28.92

 

D. MCI earning per share

• EPS = Net Income / Shares Outstanding• To calculate net income :

•Assume the EBIT keeps stable in 1996•Suppose cost of debt is 6.36%

The cost of debt of MCI is shown in Exhibit 3 or Use income statement of 1995 to get interest rate

609

4.01200018111181 xri

Npost

TIEBITEPSpost

609

4.01200018111181 xri

Npost

TIEBITEPSpost

8.0

609

88.485

609

4.01%3.620001811118

x

EPSpost

3. What is MCI’s current weighted average cost of

capital (WACC)?•Cost of equity  = 5.7+ 1.0(7)=12.7%•Cost of debt  = 6.1% (see exhibit 3)•Tax rate = 40%

•WACC= (1-0.4)(0.15)(6.1)+(0.85)(12.7)=11.3%

ED r

V

Er

V

DTcWACC )1(

Assets 19,301 3,444 Debt15,857 Equity

Total Assets 19,301 19,301 Total Liabilities

Balance Sheet (Market Value, millions)

Value

15%

85%

DebtEquity

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?

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)(0.27/0.73)]=0.8

After the leveraged recapitalization,Relevered beta = 0.9

Expected Returned

R1 = RF + β x Market Risk

= 5.7 + 0.8. 7

= 11.3 %

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 6.3% (See Exhibit 3.)Then,

WACC= (1-0.4)(0.27)(6.3)+(0.73)(12.7)=10.3%

So, Expected Returned > WACC (Profitable)

Assets 19,301 5,444 Debt13,857 Equity

Total Assets 19,301 19,301 Total Liabilities

Balance Sheet (Market Value, millions)

Value

27%

73%

DebtEquity

5. Would you recommend that MCI increase its use of debt?

If undervaluation is driving decision, a debt-financed repurchase would offer MCI more opportunity to credibly shape investors’ views.Signaling benefits and the potential increase in investment. Also indicate that the company has been aggressive in financing its growth with debt.

Conclusion

• Repurchasing some of the company's stock were succeed to enhance shareholder value

• By incresing in debt equity ratio from 36% to 72% will give lower WACC which enhanced corporate value

• More profitability result due to Rate of return higher than capital cost

Assets Liabilities and Equity19,301 CL 4,870

  LTD 3,444  Deferred taxes and others 1,385

  Shareholders’ equity 9,602

Assets Liabilities and Equity  CL 4870   LTD  5444  Deferred taxes and others  

  Shareholders’ equity  

MCI’s pre-leveraged recapitalization book value of equity

 MCI’s post-leveraged recapitalization book value of equity

Debt equity ratio

•Before repurchase

•Approximate value of debt = 3,444

•Approximate value of equity = (27.75)(681) = 18,898

•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=

 Assumption 2 - Market Capitalization Share Outstanding·         Share are repurchased at the pre purchase price of $2

7.75

Number to be purchased:  N =   2000  =   2000    = 72         P pre         27.75 N pre  - N = N post   à =  681 – 72 = 609 P post  = total market valueN post= (18898 – 2000  +  2000)/609  = 29.06                                             

Assumption 2 – P/E Pricing Approach

·         The P/E ratio is relatively stable (as repurchase decreases shares outstanding, share price rises)

·         Net income does not change

 

Suppose  a = P/E  à + = axE

 

P                      =  P’                           à   P x shares = P’ x shares’

NI/shares         NI/shares’

 

                                        27.75 x 681 = P’ x 609  à  P’  = $31.03

• MCI book value of equity

•Suppose the debt of $2000 million is LTD

•According to Exhibit 2 :

LTD/BV of Epre = 0.359

BV of Epre =

BV of Epost =

9593359.0

3444

359.0

LTD

8579681

6099593 x

•Suppose cost of debt is 6.36%

•Solution 2 : Use the estimated EPS in Exhibit 2

8.0

609

88.485

609

4.01%36.620001811118

x

EPSpost

• 2. What will be the effects of issuing $ 2 billion of new debt and using the proceeds to repurchases shares on:

• MCI’s earnings per share

• Solution 1: Assume the EBIT keeps stable in 1996

• Use income statement of 1995 to get the interest rate.

• 2. What will be the effects of issuing $ 2 billion of new debt and using the proceeds to repurchases shares on:

• MCI’s earnings per share

• Solution 2: use the estimated EPS in

• Exhibit 2.

87.0609

4.03444$

181$2000$573$

xx

EPS

87.0609

4.03444$

181$2000$573$

xx

EPS