Mci communications corp capital structure theory solution

MCI COMMUNICATIONS CORPORATION Introduction In 1982, the Justice department ordered the separation of ATT into local subsidiaries. MCI was one of the main competitors of AT&T and the impact of this new competition on MCI was uncertain. In this case the financial impact of this increased competition will be analyzed. Analysis of External Financing Needs for MCI from 1983 to 1989 Please see Exhibit 1 and Exhibit 2 MCI’s external needs will keep increasing over the next few years as the operating margins would shrink because of higher competition & higher access charges. In order to increase its market share, MCI would need to continue investing huge capitals in its network. As per exhibit 9 of the case, it is anticipated that MCI will increase its market share to 20 % in the next 6 years. The telecom industry is very capital intensive and in 1983 required $1.15 worth of investment in fixed plant & equipment for each extra $1 of revenue; that is first you have to build the network before you can sign up customers. The operating margin is expected to stabilize at 15% by 1990. But they are expected to vary substantially based on competition. It can go up to 22% or go down to 8%. Types of securities which were issued by MCI (1972-1983) 1. 2. 3. 4. 5. Common Stock Common Stock with warrant Convertible cumulative preferred stock - Cost Around 12.27 Debentures – Cost around 15% Convertible debenture – cost around 10% MCI initially issued equity in 1972 and later it started issuing debentures & convertible debentures. This was because the cost of equity is highest. MCI relied on debentures for a while and then convertible debentures which had lower cost of capital. As its equity stock price continued rising, it converted the convertible debentures to common stock thereby increasing its equity & lowering its liability. This allowed MCI to raise further capital in the future. The convertible bonds provided a cost effective way for MCI to finance a sequence of major capital investments. It allowed MCI to match capital inflows with expected investment outlays. Once the stock price rose MCI forced the conversion and 1/4 eliminated the cash flow drain from servicing the debt. The new infusion of equity can in turn be used to support additional debt or convertible financing. For exampleo MCI issued 100 million convertible offering in 1981 with a conversion price of 12.825 while the current price at that time was 10.875. o By Feb’1983, the stock price had gone above 12.825 and MCI called for conversion. It reduced its leverage. o It used this new infusion of equity to raise $400 million in the new convertible offering at conversion price of $52. This strategy worked for MCI because it was unable to satisfy its demand for huge capital from the investment grade bond markets (it had no previous track record) or from regular banks. Raising more equity would have diluted the value for existing share holders and the cost of equity would have been very high. The convertible offerings were accepted by investors at a lower coupon than straight bonds because they could get capital appreciation if the MCI stock price goes up. Analysis of Historical and Proposed Capital Structure In April 1983, the telecom industry was going through major regulatory changes. AT&T was being divided into smaller companies and equal network access costs were being established. MCI had a good opportunity to increase its market share.