Mci Communications Corp.: Capital Structure Theory (a)

10 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Susan Chaplinsky

University of Virginia - Darden School of Business

Abstract

This case provides an introductory exercise for estimating the cost of capital (cost of equity, weighted average cost of capital) for a firm contemplating a large increase in debt. Students are asked to compare the debt policy of MCI Communications with that of five other leading telecommunications companies to find MCI's optimal capital structure.

Excerpt

UVA-F-1175

Rev. Apr. 13, 2016

MCI Communications Corp.: Capital Structure Theory (A)

On a cold winter morning in February 1996, Katzu Mizuno stood admiring the panoramic view of New York Harbor. In his first five months in New York as a first-year associate for Lynch Investments, Mizuno had been pleasantly surprised to have some free time to explore the Big Apple. During this period, he had found an apartment, been to Madison Square Garden for a Knicks game, attended the symphony at the Lincoln Center, and had made frequent trips to a sushi bar in his neighborhood. The tranquility of the moment ended, however, with an urgent phone call from his boss, Anna Curti.

Earlier that morning, MCI Communications Corporation, a long-time client of the firm, had called seeking advice about establishing a program to repurchase some of its outstanding common stock. As Exhibit1 shows, throughout most of 1995, MCI's stock had been a sluggish performer in an otherwise buoyant market, and management sensed a growing restlessness on the part of shareholders. At a recent meeting of the board of directors, discussions had centered on repurchasing some of the company's stock as a means to enhance shareholder value. One long-time director, Gavin Philips, pushed hard to finance the repurchase by increasing MCI's debt financing. He argued that this action would send a bold signal to the market about the future prospects of the firm. To be effective as a signal, Philips suggested that the company would need to increase its debt-to-equity ratio from its current level of around 40% to “more or less twice that.” He said, “Even at that debt level, MCI's debt-to-cap would be moderate relative to the industry.” He estimated that such action would require MCI to issue approximately $ 2 billion in additional debt. Other directors, concerned that the increased debt burden might impede the company's current capital-expansion program, argued for a less extreme approach. They favored an open-market purchase program instead. Under that option, the company would announce its intentions to repurchase its stock from “time to time” but only as corporate funds allowed. This course of action, therefore, did not call for any increase in debt.

On hearing the directors' concerns, a senior vice president of MCI, William Duran, called Curti to seek advice on the repurchase and, in particular, whether debt financing would be advisable. Duran also indicated that since the board hoped to disclose the details of its plan to improve shareholder value by the end of the following week, it would be necessary to get back to him as soon as possible. Curti responded quickly: She assigned a second-year associate, Lance Alton, to gauge the possible interest in any debt securities that MCI might choose to issue, and she asked Mizuno to examine the consequences of substantially increasing the firm's use of debt. She instructed both of them to report their initial findings to her the following day.

. . .

Keywords: cost of capital, debt policy

Suggested Citation

Harris, Robert S. and Chaplinsky, Susan J., Mci Communications Corp.: Capital Structure Theory (a). Darden Case No. UVA-F-1175, Available at SSRN: https://ssrn.com/abstract=909400

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Susan J. Chaplinsky

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4810 (Phone)
434-243-7676 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/chaplinsky.htm

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