Andy Eko

Eka Taruna
Satam
Tegun Kamilius
Prayogi Purnapandhega

Company Profile
MCI Communications Corp.was

anAmericantelecommunications company that was

instrumental in legal and regulatory changes that led to
the breakup of theAT&Tmonopoly 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

byWorldComin 1998 and becameMCI WorldCom, with
the name afterwards being shortened toWorldComin
2000. WorldCom's financial scandals and bankruptcy led
that company to change its name in 2003 toMCI Inc..
The MCI name disappeared in January 2006 after the
company was bought byVerizon.

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 MCIs stock is

sluggish, 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.

MCIs 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. MCIs book balue of equity

o Solution-1

Total Current Liabilities

= 4870

Long Term Debt = 3444+2000=5444

Deferred Taxes and Other = 1385
Stockholders 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, MCIs debt-tocap 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

value 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=$28.92

Or, 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%
EBIT I 1 T 1118 181 2000 xri 1 0.4

Npost
609

EBIT I 1 T 1118 1 81 2000 xri 1 0. 4

Npo st
609

E PSpost

EPSpost

1118 181 2000 x6.3% 1 0.4 485.88

0.8

609
609

EPSpost

The cost of debt of MCI is shown in Exhibit 3 or

Use income statement of 1995 to get interest rate

3. What is MCIs 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%

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l1
a
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D
E

rD
rE
V
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WACC (1 Tc )

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

4. What would you expect to happen to MCIs

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 + x Market Risk
= 5.7 + 0.8. 7
= 11.3 %

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2
7
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b
t

E
q
u
i
t
y
7
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)

5. Would you recommend that

MCI increase its use of debt?
If undervaluation is driving decision, a debtfinanced 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

MCIs pre-leveraged recapitalization book value

of equity
Assets
Liabilities and Equity
19,301

CL
LTD
Deferred taxes and others

4,870
3,444
1,385

Shareholders equity

9,602

MCIs post-leveraged recapitalization book value

of equity
Assets
Liabilities and Equity

CL
LTD
Deferred taxes and others

4870
5444

Shareholders 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 $27.75
Number to be purchased:

N = 2000 = 2000 = 72
P pre 27.75

N pre - N = N post = 681 72 = 609

P post = total market value

N 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 + = axE

P = P P x shares =
P x shares
NI/shares NI/shares

27.75 x 681 = P x 609 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 =

LTD 3444

9593
0.359 0.359

609
BV of Epost =
9593x
8579
681

Suppose cost of debt is 6.36%

1118 181 2 000x 6. 36% 1 0.4 485.88
609 0.8
609

EPSpost

Solution 2 : Use the estimated EPS in Exhibit 2

EPS

$573 $2000 x

2. What will be the effects of issuing $ 2 billion of new

debt and using the proceeds to repurchases shares
on:

MCIs 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:

MCIs earnings per share

Exhibit 2.

Solution 2: use the estimated EPS

in

609

$181
x 0 .4
$3444
0.87

EPS

$573 $2000 x
609

$181
x 0 .4
$3444
0.87