Some background introductions of our target firm, WorldCom. and industry, as well as some macro-economic factors before the bond issue. Explain generally about the needs of capital for WorldCom to issue corporate bonds.

AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Page 8 UV0267 Exhibit 3 WorldCom, Inc.: Corporate Bond Issuance Selected Financial Information for WorldCom, Inc. (in thousands of dollars, except ratios and per-share data) 1997 1996 1995 1994 Revenues $7,351,354 $4,485,130 $3,696,345 $2,245,663 Operation income (loss) 1,098,606 (1,844,094) 675,144 66,528 Interest expense 319,700 221,800 249,100 47,300 Income (loss) before extraordinary item 383,652 2,188,944) 266,271 (124,013) Extraordinary item (24,434 Net income (loss) 383,652 (2,213,378) 266,271 (124,013) Preferred dividend requirement 26,433 860 33.191 27,766 EPS-basic before ex item 0.40 5.50) 0.67 0.48 EPS-diluted before ex item 0.40 (5.50) 0.64 (0.48) EPS-basic 0.40 (5.56) 0.67 0.48 EPS-diluted 0.40 (5.56) 0.64 (0.48 Shares outstanding-basic 898,889 397,890 346,666 $15,610 Shares outstanding-diluted 959,816 397,890 402,577 315,610 Total assets 22,389,553 19,963,1976 6,656,629 3,441,474 Long-term debt 6,527,207 4,803,581 3,391,598 794,001 Shareholders' equity 13,509,865 12,959,976 2,187,681 1,827,410 Debt/total assets 39.7% 34.7% 67.0% 46.7% Quick ratio 0.6 0.6 0.3 0.7 Current ratio 0.8 1.2 0.8 Asset turnover 0.3 0.3 0.7 07 Return on equity 2.8% -17.1% 12.2% -6.8% Return on assets 1.7% -1.1% 4.0% -3.6%AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Page 10 UV0267 Exhibit 5 WorldCom, Inc.: Corporate Bond Issuance Moody's Bond-Rating Definitions Aaa Bonds that are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edge." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa Bonds that are rated Aa are judged to be of high quality by all standards. Together with the Aaa group, they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuations of protective elements may be of greater amplitude or there may be other elements present that make the long-term risks appear somewhat larger than in Aaa securities. A Bonds that are rated A possess many favorable investment attributes and are to be considered upper- medium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present that suggest a susceptibility to impairment sometime in the future. Baa Bonds that are rated Baa are considered medium-grade obligations (ie., they are neither highly protected nor poorly secured). Security for interest payments and principal appears adequate for the present, but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics, and in fact have speculative characteristics as well. Ba Bonds that are rated Ba are judged to have speculative elements; their future cannot be considered well assured. Often, the protection of interest and principal payments may be very moderate and therefore not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B Bonds that are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period may be small. Caa Bonds that are rated Caa are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest. Ca Bonds that are rated Ca represent obligations that are speculative to a large degree. Such issues are often in default or have other marked shortcomings. C Bonds that are rated C are the lowest-rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. Data source: Moody's Industrial Mannal (1995), p. vi.AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Gary Brandt, treasurer of WorldCom, Inc., could not remember a year quite like the last. WorldCom had stunned the financial community in November 1997 with a $37-billion bid for MCI Corp., besting rival bids by British Telecommunications (BT) and GTE. Now WorldCom was about to do the same in the corporate bond market as it readied to issue what could be the largest corporate debt issue ever. With the MCI deal scheduled to close soon, financing had to be arranged to repurchase the 20% stake BT held in MCI. WorldCom announced-through its investment banker, Salomon Smith Barney-intentions to market $3 billion to $4 billion of debt in the first week of August 1998. If there was sufficient demand, the offering could be increased to $6 billion, exceeding by a considerable margin the previous record of $4.3 billion, set by Norfolk Southern Railroad in May 1997.' The market reception and pricing of the bond were made more difficult by the turbulent conditions in the bond and equity markets in recent weeks. Brandt had received some preliminary estimates of the costs of the issue from his bankers. But because it would be the firm's task, not the bankers', to see that the terms of the debt were eventually met, he decided to develop his own estimate of the costs of the new bonds. Company WorldCom was started in 1983 in Hattiesburg, Mississippi, as Long Distance Discount Services (LDDS) by Bill Fields and a group of investors that included Bernie Ebbers. The breakup of AT&T, in 1983, encouraged other companies to enter the long-distance telephone business. LDDS leased a Wide Area Telecommunications Service (WATS) line and resold time to other businesses. The firm initially did well until WATS line prices increased. Following a period of losses, the board appointed Ebbers chief executive officer (CEO) in 1985. Ebbers immediately instituted cost-control measures, began stressing customer service to new clients, and customized each client's service to its calling patterns. Within six months, LDDS was back in the black. LDDS capitalized on its own success by acquiring other long-distance start-ups experiencing similar trouble. Employing the same turnaround procedures with other failing companies, LDDS was able to greatly expand its business at low cost. In 1989, LDDS merged with Advantage Company, a publicly traded long- distance telephone company, making LDDS public as a result. By the end of 1991, the company had purchased five additional companies, for a total of $100 million, expanding its network to 27 states. In 1992, If successfully completed, the WorldCom offer would also overshadow the largest junk-bond offering: RJR Holdings Capital's $6.11-billion deal priced in 1989. Because many of the RJR bonds sold at discount, proceeds amounted to only $4 billion. 2 Information on WorldCom's history as developed from and Dow Jones News RetrieAFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X LDDS merged with Atlanta-based Advanced Telecommunications and became the fourth-largest long- distance carrier in the United States. The pace of acquisitions increased as the prominence of the company grew. In 1993, LDDS merged with Metromedia Communications and Resurgens Communications Group. LDDS Communications merged with IDB Communications Group, a satellite-communications company, in late 1994. The next year, the company spent $2.5 billion for William Cos. subsidiary WilTel's 11,000-mile fiber-optic cable network. To reflect its growing global aspirations, the company changed its name to WorldCom in 1995. The Telecommunications Act of 1996 substantially rewrote the industry's rules by allowing local-access telephone companies and long-distance companies to compete against each other. WorldCom took advantage of the change with the $14.4-billion purchase of local-access provider MFS Communications in 1996, which included the subsidiary UUNET Technologies (an Internet access provider). With WorldCom's subsequent acquisitions of the America Online networks (ANS Communications) and CompuServe networks CompuServe Network Services), the company became a leader in this rapidly growing market. As a result of the MFS merger, WorldCom became the first company since the breakup of AT&T to offer local and long- distance services over its own network. All of the previous acquisitions, however, paled in comparison to WorldCom's offer to purchase MCI Corp. for $37 billion in November 1997. The offer nullified MCI's previous pact with British Telecommunications and beat a rival bid from local-service provider GTE. Completion of the deal would move WorldCom from being the fourth-largest long-distance telephone company in the United States to being second only to AT&T. The combined company, MCI-WorldCom, would have more than $30 billion in 1998 revenues. The boards of directors of both companies unanimously approved the transaction. The Bond Issue In January 1998, the firm filed a shelf-registration statement with the U.S. Securities and Exchange Commission seeking permission to raise up to $6 billion over the next two years. Most market observers expected WorldCom to raise this amount of funding through several smaller debt offers, and thus were somewhat surprised to learn in July that all $6 billion might be raised in one offer. WorldCom planned to use its own stock to buy the public shares of MCI that did not belong to British Telecommunications. As part of the deal, WorldCom agreed to pay BT $6.94 billion in cash for its 20% stake in MCI. WorldCom had a large commercial-paper program, however, and MCI was cash rich following the sale of its Internet business to Cable & Wireless for $1.75 billion. In addition, WorldCom had recently agreed to a new $12-billion bank credit facility. The credit facility consisted of a $5-billion term loan due in 2002 and a $7-billion, 364-day revolver that could be renewed for two more years. All these factors seemed to argue in favor of a smaller public offer. WorldCom did appear to have continuing cash needs to fund future acquisitions and large-scale capital improvements. Just the previous week, MCI had announced the purchase of Brazil's long-distance carrier, Embratel, for $2.3 billion. WorldCom was spending $2.5 billion a year to improve its infrastructure.AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Page 3 UV0267 For his part, Brandt believed that WorldCom had ample need for the funds, and he was hopeful that market conditions would be such that the firm could raise $6 billion in one shot. Initially, he planned to use the bank debt to pay BT, and thereafter to pay off the bank debt with the newly issued bonds. The issue called for four tranches of debt to be offered: . $1.5 billion in 3-year notes $1.0 billion in 5-year notes $2.0 billion in 7-year notes $1.5 billion in 30-year bonds Following market convention, the debt issues would carry an annual fixed coupon rate, but interest would be payable to holders on a semiannual basis. No specific assets or collateral were pledged on the bonds, and only a few standard covenants appeared in the indenture. In the words of one market observer, WorldCom's offer was "plain-vanilla debt-a whole lot of plain-vanilla debt." Exhibit 1 lists the covenants on the credit facility and proposed public bond issue. From the firm's point of view, now seemed to be a good time to issue. The MCI merger had boosted awareness and interest in the firm. Investors had responded favorably to the announcement of the merger. (Exhibit 2 presents evidence on the stock-price response to recent telecommunications mergers.) The company had cobbled together various communications companies to offer business customers everything from domestic and long-distance telephone service to Internet access, and by the summer of 1998, many observers viewed WorldCom as the industry leader. "They're the farthest ahead in giving the customer end- to-end telecommunications solutions. They have the model that the other phone companies are trying to emulate," said Patrick Cassidy, an analyst at T. Rowe Price.5 In addition to the glow of the MCI-WorldCom merger, WorldCom had recently reported second-quarter revenues of $2.61 billion, a 45% increase over the same period of the previous year. Net income was $228 million, compared with $44 million the previous year. Exhibit 3 gives selected information on WorldCom's financial performance. Exhibit 4 compares WorldCom with other long-distance telephone companies. It was widely believed by market observers that WorldCom's debt, which was currently rated Baa2 by Moody's Investors Service and BBB+ by Standard & Poor's, would be upgraded to the low single-A area in the upcoming year. Exhibit 5 provides the bond-rating definitions.AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Market Conditions The devaluation of the Thai currency in June of 1997 precipitated a major financial crisis that spread to Malaysia, Indonesia, Korea, Hong Kong, and other regional markets over the ensuing months. In its wake, these countries experienced depressed economic conditions and plummeting equity markets. U.S. financial markets also experienced considerable turmoil and uncertainty over the extent that the global crisis would hurt the U.S. economy. These concerns were most acute in the months following the Hong Kong crisis in October 1997, and eased somewhat in the first half of 1998, as the U.S. economy showed continued strong performance. In mid-July, however, fears of a deepening crisis resurfaced. The Japanese yen deteriorated to 5 "WorldCom Readies for a Record Investment Grade Deal and Corporate Bond Yields Rise in Anticipation," Barron's (August 3, 1998): MW11. This document is authorized for use only in Daniel Ding's AFIN8012 Fixed income securities and credit analysis - $2 2022 at Macquarie University from Sep 2022 to Mar 2023. Page 4 UV0267 an eight-year low against the U.S. dollar, as investors lost confidence in the government's ability to resolve its banking crisis. The weakness in Japan threatened to engulf China, which had resisted devaluing its currency. In addition, the domestic U.S. economy showed signs of slowing corporate profitability in the second quarter. Finally, a mounting political crisis threatened the U.S. president, Bill Clinton, raising concerns about his effectiveness and tenure in office. All these factors combined to take a toll on the U.S. equity markets. The Dow Jones Industrial Average dropped 99 and 300 points on Monday and Tuesday of the projected issue week. Tuesday's drop was the third-largest percentage loss in Dow history. Similar percentage losses were registered for the S&P 500 and NASDAQ averages. Analysts were sharply divided on the portent of these events for future economic activity. As money left the stock market, some flowed into corporate and Treasury securities. Exhibit 6 gives information on the movements in interest rates in recent weeks. Exhibit 7 provides a longer-term view of corporate and government rates and spreads.AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X A second factor of concern was the large volume of debt issues scheduled for issuance in the first week of August. A heavy calendar of debt issues had been a feature of the market all year. Investment-grade issues were on course to beat last year's record, while high-yield issues were already within striking distance of last year's record. Some $40 billion in debt issues, two to three times the usual amount, was scheduled to price the same week as WorldCom's issue. The large supply coming to market put pressure on corporate bonds. The recent turmoil had also raised concerns among investors about the quality of the debt. Jacques de St. Phalle, head of fixed income at Bear Stearns, noted that "investment-grade companies were taking two to three days to market deals before pricing them. That's something only junk-bond investors with complicated stories used to take time out for. And when new deals do get sold, they are priced at a concession to issues already outstanding." Long-term corporate yield spreads over Treasuries had increased over the last several weeks. Further widening of the spread could occur if the markets did not settle soon (Table 1). Table 1. Volume of U.S. security issues. in billions of $US) 1998 1997 1997 1996 through 6/30) through 6/30) Corporate debt Investment grade $380.0 $246.0 $721.5 $510.0 High yield 99.8 58.3 125.0 72.2 Common stock $ 73.0 $ 47.2 $118.0 $115.0 Source: Security Data Corporation. In the days leading up to the issue, the firm's investment bankers gathered information from market sources in anticipation of the final pricing meeting, scheduled for August 6. The syndicate desk at Salomon Smith Barney was responsible for pricing the new bonds. The pricing process began by determining the "price talk" for the new issue. Basically, this amounted to finding the approximate spread over Treasuries that investors would demand for each tranche of debt. Once the syndicate desk set the price talk, the deal was marketed to investors and the "book" was built. The book was simply the number of orders for WorldCom bonds received at each spread level in the price talk. If investors were clamoring for the deal, then the bond would carry a low spread and yield to maturity (i.e., price at the tight end of the price talk). Otherwise, the syndicate desk would need to increase the spread in order to attract enough investor interest. " Investment-grade debt typically had rating classifications of BBB, Baa, or better. High-yield or so-called junk bonds had ratings of BB, Ba, or below. 7 "WorldCom Readies for a Record Investment Grade Deal," MW11.AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Page 5 UV0267 Exhibit 8 contains basis-point spreads for corporate debt over comparable-length Treasury securities for various bond-rating categories. Although the spreads pertained to industrial issues, Brandt believed they would offer some basis for estimating the yield to maturity on WorldCom's new bonds. In addition, he had assembled data on the recent prices of the bonds of telecommunications and media firms (Exhibit 9), which might serve to indicate what investors expected by way of return.C AFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X This file has limited permissions. You may not have access to some features. View permissions File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf Page 6 UV0267 Exhibit 1 WorldCom, Inc.: Corporate Bond Issuance 2 Case Study: WorldC X Covenants Contained in WorldCom's Proposed Public Bonds and New Bank Credit Facility Public Bond Covenants Description Rationale Mergers, Consolidations, The Company may consolidate with, or sell, lease or convey all or substantially all of its Restrict mergers, consolidations, or and Transfer of Assets assets to, or merge with or into any other corporation, provided that in any such case, sale of all of an issuer's assets that either the Company shall be the continuing corporation, or the successor corporation would result in an impaired credit shall be a corporation organized and existing under the laws of the United States and shall from the perspective of the creditor. assume all covenants of this indenture. Limitation on Liens The company shall not, and shall not permit a subsidiary to, create any Lien upon any of Protect relative seniority to income its Property or assets, whether now owned or hereafter acquired, unless it has made or producing assets. will make effective provision whereby the Securities will be secured by such Lien equally and ratable with all other indebtedness of the Company. Credit Facility Covenant Description Rationale Q some background i X Limitations on Additional Limits the ability of the Company to incur additional indebtedness unless the Company Limit additional debt unless cash flow Indebtedness exceeds a specified ratio of EBITDA to interest expense or maintains a certain level of is sufficient to service it. Maintain total debt to total capitalization on a pro forma basis. credit quality/ rating. Limitations on Asset Sales The Company cannot make an Asset Sale unless the Board of Directors determines that Maintain "asset coverage" of debt and Disposition of Asset the Company receives Fair Market Value and unless at least a portion of the proceeds ensure assets remain dedicated to Sales Proceeds from the Asset Sale are received in cash. Proceeds from the sale may have to be used to main lines of business; retain relative repay Senior Debt or invest in the business within one year. risk profile of investment. Additional Situational In WorldCom's case, $7 billion of the credit facility will be reduced to $3 billion if the The large credit facility was extended Covenants MCI/WorldCom merger is not complete by October 5th, 1998. Any amount outstanding with the understanding that MCI's on the credit facility above and beyond $3 billion would have to be prepaid by the additional cash flow would support it. company at that point. Limitations on Restricted An incurrence test that limits the ability of the Company to pay dividends, repurchase Prevent cash from leaving Company Payments and Investments stock or make investments in certain entities (eg., joint ventures). The Company may be prevent Company from prioritizing Part A Some backgr X able to make "Restricted Payments" over time of up to 50% of Consolidated Net Income its cash flow for the benefit of junior plus a defined "Restricted Payments Basket." creditors/equity. Source: All exhibits, unless otherwise specified, were created by author. To THE ACCOUNTING I X + X . . XAFIN8012_SHFYR_2 X PDE UV0267-PDF-ENG ( X 2 Case Study: WorldC X Q some background i X Part A Some backgr X THE ACCOUNTING I X + X C File | C:/Users/admin/Downloads/UV0267-PDF-ENG%20(2).pdf To . . This file has limited permissions. You may not have access to some features. View permissions X Page UV0267 Exhibit 2 WorldCom, Inc.: Corporate Bond Issuance Stock-Market Response to Recent Telecommunications Deals from Announcement of Deal through Closing Date or July 31, 1998, Whichever is Sooner Percentage Change from Deal Announcement to Close Proposed Transaction Date Share S&P Industry Announced Price 500 Index Buyers Bell Atlantic agrees to acquire NYNEX April 22, 1996 +36% +75% +56% Deal closed August 14, 1997 SBC Corporation will buy Pacific Telesis April 1, 1996 +66% +74% +61% Deal closed April 1, 1997 WorldCom agrees to buy MCI1 Nov. 10, 1997 +72% +220% +40% AT&T will buy cable company, TCI' June 24, 1998 -2% -1% +4% Sellers MCI agrees to be bought by WorldCom Nov. 10, 1997 +57% +22% +40% Ameritech agrees to be bought by SBC' May 11, 1998 +8% +20/ +3% ' Deal pending as of July 31, 1998 Data source: Wall Street Journal, July 31, 1998, C1