Capital Structure and firm value

MCI Communications, Corp, is now evaluating a program to repurchase some of its outstanding common stock. MCIs stock had been a sluggish performer in an otherwise buoyant market, and management sensed a growing restlessness on the part of shareholders. The current stock price is $27.75/share. At a recent meeting of the board of directors, discussion had entered on repurchasing some of companys stock as a means to enhance shareholder value. One longtime director, Gavin Philips, pushed hard to finance the repurchase by increasing MCIs debt financing. He estimated that such action would require MCI to issue approximately $2 billion of debt. Other directors, concerned that the increased debt burden might hurt the companys credit, argued for a less extreme approach.

On hearing the directors concerns, a senior vice president of MCI, William Duran, called his financial analyst Curti for advice. Curti quickly collected information about the company, Exhibit 2 contains financial data for the company. In assembling the data, Curti made several assumptions. First, she decided to assume that tax rate is 40%. Second, she assumed that the risk free rate is 3%, market risk premium is 5.5% and the companys current beta is 1.1. The companys cost of debt is 4.4%.

Curti recalled from her finance classes that the maximum value of the firm corresponded to the lowest overall cost of capital. So she intended to compare the companys cost of equity and WACC before and after the debt financing and stock purchase program.

1. Based on MM model, how much would be MCIs stock price after the company issued $2,000 million to buyback stocks? How many shares can be repurchased? What would be earning per share after the stock repurchase.
2. What is MCIs current cost of equity and WACC? (Use market value based capital structure, and debt only includes long-term debt). What would be its cost of equity and WACC if the company issue $2 billion debt and use the proceeds to buyback stocks?
3. Would you agree with Gavin Philips to issue $2 billion debt or would you agree with other directors to take a less aggressive plan and issue less debt?

Exhibit 2 MCI Income Statement ended in December 31, 1995 (in millions) revenue cost 15,265 7,813 4,506 1,308 520 1,118 181 S&A depreciation assets write down EBIT interest Taxable Income tax Net income shares outsatnding earning per share 937 364 573 681 0.84 MCI Balance Sheet ended in December 31, 1995 (in millions) current asset cash and cash equivalents marketable securities receivables other total current asset 706 3,664 500 4,870 current liablity 471 account payable 373 accrued expense 2,954 long-term debt due within one year 749 total current liability 4,547 long-term debt 14,243 deferred taxes and others 5,238 1,304 total noncurrent liability 10,309 shareholders equity 4,445 3,444 1,385 property and equipment accumulated depreciation construction in progress net total property and equipment 4,829 9,602 oter assets total assets 19,301 total liability and equity 19,301 Exhibit 2 MCI Income Statement ended in December 31, 1995 (in millions) revenue cost 15,265 7,813 4,506 1,308 520 1,118 181 S&A depreciation assets write down EBIT interest Taxable Income tax Net income shares outsatnding earning per share 937 364 573 681 0.84 MCI Balance Sheet ended in December 31, 1995 (in millions) current asset cash and cash equivalents marketable securities receivables other total current asset 706 3,664 500 4,870 current liablity 471 account payable 373 accrued expense 2,954 long-term debt due within one year 749 total current liability 4,547 long-term debt 14,243 deferred taxes and others 5,238 1,304 total noncurrent liability 10,309 shareholders equity 4,445 3,444 1,385 property and equipment accumulated depreciation construction in progress net total property and equipment 4,829 9,602 oter assets total assets 19,301 total liability and equity 19,301