MCI Communication case study
...re equity) option. Finally, a WACC will be calculated to fully examine the effects of each option of the firm’s overall cost of capital. Flexibility – In order for a firm to have more flexibility, it would prefer debt as opposed to equity. With debt the firm has more control over it’s own functions, since it has less stockholders. Also, in general a firm can request funds from their bank or issue bonds more easily than they can issue more stock through an investment bank. Risk – A company has more financial risk with increased debt, but has more business risk with an increase in equity. So, to limit the amount of financial risk that the company has, equity is advantageous. Not being able to pay interest payments on debt in a timely manner will result in default and possible bankruptcy. Income – A company’s amount of income is more important when considering debt and less important when considering the equity alternative. Equity’s common stock dividends only have to be paid out when the extra corporate funds are available, while interest on debt needs to be paid each month. Hence using the debt alternative means that there must be sufficient income, while using the equity option has less important implications on a company’s current level of income. In this way, it is important that MCI still have the necessary income to pay its interest on the increased $2 billion dollars in debt, which must be looked at especially since there must be a reason why their stock has been performing sluggishly. If MCI does not have the income needed for the payments, it should not choose to take out the debt, and should consider the option to wait and pay with extra corporate funds or not repurchase stock at this time. Control – A firm essentially loses control as they increase their amount of equity because the shareholders gain some control of the company in terms of decision-making power. In MCI’s case, the lack of total control by the company is demonstrated in the way that MCI must consider stockholder’s reactions and consult with their key stakeholders before implementing any of the proposed options. Timing – It is important to consider timing in determining a company’s optimal capital structure. For MCI, taking out the debt will allow it to repurchase the stock immediately. This will have an immediate effect on the perception of the company’s future prospects. Announcing the open market purchase program may in fact have a similar effect, but the effect will not be as drastic. Furthermore, MCI’s debt/equity ratio will not be changed by such a large amount as quickly. Currently, MCI’s amount of debt and debt/equity ratio is far less than that of its competitors. Since MCI is still relatively on the low-end of debt, increasing its amount of debt to match its competitors’ (the norm) range of debt would support the present as a right time to invest using the debt alternative. Other concerns – A concern for MCI in using debt is that debt will change its beta. Although the company’s risk premium will not change significantly, the change in beta will lead to an increased cost of equity. This will, in turn, increase the firm’s overall cost of capital. A second concern for MCI is its shareholders’ reactions to their decision. Some shareholders may object to the change in capital structure, which may cause problems for MCI in the future. Scenario Analysis MCI’s decision was analyzed under a worst, most-likely, and best-case scenario for both the debt increase and status quo options. The base information for future analysis was obtained from MCI’s 1995 income statement [Exhibit 4], except for number of shares outstanding, which was obtained from Exhibit 2’s financial characteristics. A good estimate for MCI’s most-likely growth is its projected 5-year earnings per share growth of 11.5%. As a result, the 1996 most-likely estimated totals are expected to be the same as 1995 plus the 11.5% growth. The 11.5% is also mid-way between highest (13.5%) and lowest (8.5%) of the telecommunications firms being compared. The worst and best-case numbers are then estimated at the arbitrary –/+ 3% of the most-likely estimate. Status Quo Base Worst Case Most Likely Best Case Operating Income (EBIT) $ 1,118.00 $ 1,213.03 $ 1,246.57 $ 1,280.11 Interest Expense $ 181.00 $ 196.39 $ 201.82 $ 207.25 Taxable Income $ 937.00 $ 1,016.65 $ 1,044.76 $ 1,072.87 Taxes $ 364.00 $ 394.94 $ 405.86 $ 416.78 Net Income $ 573.00 $ 621.71 $ 638.90 $ 656.09 Shares Outstanding $ 681.00 $ 681.00 $ 681.00 $ 681.00 EPS (status Quo)* $ 0.84 $ 0.91 $ 0.94 $ 0.96 Additional Debt Base Worst Case Most Likely Best Case Operating Income (EBIT) $ 1,118.00 $ 1,213.03 $ 1,246.57 $ 1,280.11 Interest Expense (old + new) $ ...