Assignment for MCI

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.