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 Exhibit 1 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.

Mizuno decided to compare MCI with its major competitors in long-distance telecommunications. He grew
somewhat alarmed, however, when his initial screen of peer companies produced approximately 40 firms in

This case was prepared by Susan Chaplinsky, Associate Professor of Business Administration, and Robert S. Harris, Professor of Business
Administration, University of Virginia. Support for this work came from funds provided by both the Darden School Foundation and the TVA. This
case is drawn entirely from public data. All persons and events recounted are fictionalized to facilitate the teaching objectives of the day. Copyright ©
1997 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by
any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.
Page 2 UVA-F-1175

long-distance communications.1 He knew that not all of those firms could be considered comparable to MCI
based on their business risk, the markets they operated in, and their tax and regulatory environments. After
comparing them to MCI on those dimensions, he narrowed his list to certain companies (Table 1).

Table 1. Description of industry comparables.

Company Description

Ameritech Ameritech is a holding company for Illinois, Indiana, Michigan, Ohio, and Washington
State Bells and other subsidiaries, providing communications services directly to 75% of
the population in those states. In 10/83, Ameritech became the first regional holding
company to offer cellular phone service (21 million POPs). 1994 revenue breakdown:
local service, 42%; long distance, 12%; network access, 23%; other, 23%. Purchased
49.9% stake in Telecom Corporation of New Zealand on 9/90 (now 25% after
additional equity offerings). Ameritech will be among the first of the Baby Bells to offer
long-distance telephone services. Bond rating AA2.

AT&T AT&T Corporation is the world’s largest long-distance telephone company. Formerly
American Telephone and Telegraph, AT&T resulted from a court-ordered breakup of
the Bell System in 1983, when it received about 23% of the former company’s assets.
AT&T operates in global information management, financial services, and leasing. 1994
revenue breakdown: telecommunication services, 59%; product and system sales, 28%;
rentals & other, 10%; financial services and leases, 3%. Acquired McCaw Cellular in ’94,
NCR in ’91; LIN Broadcasting in ’95. Bond rating AA3.

MCI MCI Communications Corporation, the second-largest long-distance carrier, offers

Communications long-distance services domestically and internationally. Primary business is U.S. voice,
using MCI’s 3,556 million circuit-mile microwave and fiber network. Offers 800 service,
operator assistance, worldwide direct dialing, fax, and 900 service. British Telecom holds
Class A common stock representing a 20% voting interest. Bond rating A2.

Sprint Sprint Corporation operates the second-largest independent-telephone system in the

Corporation United States. Merged with Centel Corporation in a pooling of interests in March 1993.
Provides long-distance services through US Sprint and local telecommunication services
to 6.65 million access lines. Cellular business serves a market of 20.2 million POPs. Also
has directory publishing and supply distribution operations. 1994 revenue breakdown:
long distance, 53%; local phone, 34%; other, 13%. Bond rating BBB–.

Worldcom, Inc. Worldcom, Inc., (formerly LDDS Communications, Inc.) is the fourth-largest long-
distance carrier in the nation. The company offers long-distance service through its
15,000-mile owned-and-leased network. Serves the entire United States and points to
230 countries. The company derives a predominant share of its total revenues from sales
to commercial customers. Products include switched and dedicated lines for voice and
data. Acquired IDB Communications, 12/94; WiTel Network Services, 1/95. Bond
rating BBB−.

1 The domestic companies competing with MCI in telecommunication services were Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis,

SBC Communications, US West, AT&T, Sprint, Worldcom, Frontier Communication, GTE, So. New England, IntelCom, and MFS Communications.
In addition, there were 25 international telecommunication services companies.
Page 3 UVA-F-1175

Exhibit 2 contains financial data for the peer companies. In assembling the data, Mizuno made several
assumptions to help ensure consistency across the peer firms. First, although he was not certain of the tax status
of each firm, he decided initially to assume that all companies faced a 40% tax rate. Second, it was the usual
practice at Lynch to use a market-risk premium of 7.0%, the latest estimate of the arithmetic mean return of
stocks over Treasury bonds.

Mizuno recalled from his finance classes that the maximum value of the firm corresponded to the lowest
overall cost of capital. Thus, he intended to estimate what the cost of equity and the weighted-average cost of
capital (WACC) might be if MCI pursued this capital-structure change. After discussions with other personnel
at the bank, he concluded that the higher debt-to-equity ratio would increase MCI’s borrowing costs from its
current level of 6.3%. Exhibit 3 contains the capital market rates as of February 15, 1996, from which an
estimate of the revised borrowing costs could be obtained. But what would the cost of equity (KE) be? Mizuno
decided that one approach was through “levering” and “unlevering” betas using Equation 1:

βE,L = βU(1 + D(1 − T)/E) (1)

where:

βE,L and βU are the betas for levered and unlevered equity, respectively
D and E are the market values of debt and equity, respectively
T is the corporate tax rate2

In addition to the information on peer firms, Exhibit 4 and Exhibit 5 contain the latest income statement
and balance sheet for MCI. This information could be used to estimate the expected changes in earnings per
share that would occur at different levels of operating income (EBIT) with a debt-financed stock repurchase.
The beginnings of an EBIT/EPS analysis are formulated in Exhibit 6. Mizuno knew that this analysis and its
implications would be of great interest to MCI’s senior management.

As Mizuno prepared to tackle the analysis, he was concerned that his approach might not capture all the
complexities of the decision. While shareholders’ required returns typically increase as a firm uses more debt
financing, he knew that the theoretical predictions of the cost of equity were only approximations. Mizuno had
prepared a “to do” list from his readings on capital costs (Exhibit 7) and thought those might help guide him
through the analysis. To be sure no issues had been ignored, he would pursue a three-pronged approach: (1)
examine the effects of debt on the firm’s future coverage ratios under both expected and downside cash flow
projections, (2) check with Alton on the reactions gathered from potential creditors (i.e., would severe
covenants be required?), and (3) review the company’s need for future flexibility and consider how this financial
strategy might affect business decisions.3

It would be a long night ahead. But before he pursued those additional issues, Mizuno decided to start with
the guidance theory offered.

2 For a discussion of the underlying principles and the rationale for the equations developed here, see Susan Chaplinsky and Robert Harris, “The

Effects of Debt Equity Policy on Shareholder Return Requirements and Beta” (UVA-F-1168), (Charlottesville, VA: Darden Business Publishing, 1997).
3 A useful framework for analysis is the FRICTO framework in which the analyst looks at flexibility, risk, income, control, timing, and other factors.
Page 4 UVA-F-1175

Exhibit 1
MCI Communications Corp.: Capital Structure Theory (A)
Telecommunications Industry Stock Price Performance
(value of $1,000 investment made January 22, 1993, as of December 29, 1995)

Telecommunications Industry Stock Price Performance

Value of $1,000 Investment Made January 22, 1993, as of December 29, 1995

$1,500.00

$1,400.00
MCI
$1,300.00
S&P 500
$1,200.00

$1,100.00

$1,000.00

$900.00

$800.00

$700.00
AMEX N. American Telecom
$600.00

$500.00

Stock/Index Total Return

MCI Communications 25.53%
S&P 500 41.23%
AMEX N. American Telecom 30.25%

Data source: Bloomberg.

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Exhibit 2
MCI Communications Corp.: Capital Structure Theory (A)
Financial Characteristics for Long-Distance Telecommunications Firms

1 Stock betas are from Bloomberg, Inc., and Value Line.

2 Estimated 1996 year-end EPS.
3 Based on 1996 estimated EPS.
4 Growth rates in EPS are from Value Line.
5 Firm value is the sum of long-term debt (LTD) and the market value of equity.

Data sources: February 1996 Salomon Brothers Global Equities Report and Value Line. Financial statement data are from year-end 1995.
Page 6 UVA-F-1175

Exhibit 3
MCI Communications Corp.: Capital Structure Theory (A)
Capital-Market Conditions

U.S. Treasury Obligations Yield

3-month bills 4.898%
6-month bills 4.894%
1-year notes 4.832%
2-year notes 4.872%
3-year notes 4.977%
5-year notes 5.235%
10-year notes 5.697%
30-year notes 6.168%

Corporate Debt Obligations (10-year) Yield

AAA 6.030%
AA1 6.160%
A1 6.190%
BBB1 6.470%
BB1 7.090%
BB2 8.260%
B1 9.420%
AAA phones 6.090%
AA1 phones 6.150%
A1 phones 6.260%
BBB1 phones 6.460%

Other Instruments
Federal Reserve Bank discount rate 5.125%
Certificates of deposit (6-month) 4.633%
Commercial paper (6-month) 4.840%

Data source: Bloomberg.

Page 7 UVA-F-1175

Exhibit 4
MCI Communications Corp.: Capital Structure Theory (A)
Income Statement

Year ended December 31 1995

(in millions, except per-share amounts)

REVENUE $15,265

OPERATING EXPENSES
Telecommunications 7,813
Sales, operations, and general 4,506
Depreciation 1,308
Asset write-down 520

Total operating expenses 14,147

INCOME FROM OPERATIONS 1,118

Interest expense 181

INCOME BEFORE INCOME TAXES AND EXTRAORDINARY ITEM 937

Income tax provision 364

Income before extraordinary item 573

NET INCOME $573

Earnings applicable to common stockholders $573

EARNINGS PER COMMON AND COMMON

EQUIVALENT SHARES

Income before extraordinary item $0.84

Total $0.84

Weighted-average number of common shares 681

Source: Company documents.

Page 8 UVA-F-1175

Exhibit 5
MCI Communications Corp.: Capital Structure Theory (A)
Balance Sheet

December 31 1995
(in millions)

ASSETS

CURRENT ASSETS
Cash and cash equivalents $471
Marketable securities 373
Other current assets 749

TOTAL CURRENT ASSETS 4,547

PROPERTY AND EQUIPMENT 14,243

Accumulated depreciation (5,238)
Construction in progress 1,304

TOTAL PROPERTY AND EQUIPMENT, NET 10,309

OTHER ASSETS 4,445

TOTAL ASSETS $19,301

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES $1,206

Accrued telecommunications expense 1,936
Other accrued liabilities 1,728

TOTAL CURRENT LIABILITIES 4,870

Long-term debt 3,444

Deferred taxes and other 1,385

TOTAL NONCURRENT LIABILITIES 4,829

STOCKHOLDERS’ EQUITY 9,602

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $19,301

Source: Company documents.

Page 9 UVA-F-1175

Exhibit 6
MCI Communications Corp.: Capital Structure Theory (A)
EPS versus EBIT

Interest rate on old debt Interest rate on new debt

Pre-recap debt Added debt
Tax rate Tax rate

Most Most
Status Quo Worst Case Likely Best Case Additional Debt Worst Case Likely Best Case
Operating income (EBIT) Operating income (EBIT)
Interest expense Interest expense (old + new)
Taxable income Taxable income
Taxes Taxes
Net income Net income
Shares outstanding Shares outstanding
EPS (status quo) EPS (w/new debt)

EPS

EBIT
Source: Created by author.
EBIT
Page 10 UVA-F-1175

Exhibit 7
MCI Communications Corp.: Capital Structure Theory (A)
Analysts’ Checklist for Cost-of-Capital Estimates

Principle Why Specific Implications

Think like an investor and You are estimating investor-required returns for the future. Avoid using historical costs such as the historical interest rate.
be forward looking.
Use financial market data. Use market values and other financial market data because that’s what Use market value weights and forward-looking estimates of debt costs,
investors deal with. equity costs, and tax rates.
Find comparable companies Different levels of risks carry different required rates of return. Try to find companies that are comparable on important risk dimensions.
with similar business risk. These may include lines of business, international activity, competitive
position, and strategic plans.
Be sensitive to tradeoffs in If you focus on the one “best” comparable, you have higher chances of Look at both industry averages and specific comparables. If they differ,
looking for the best large estimation errors in statistical estimates you may be using (e.g., think about why.
comparable versus using betas). If you include a wide range of comparables, estimation errors
many companies. may average out but you may not have as good a match on risk.
Cost of equity must reflect Shareholder required returns (and betas) are based on both business risk The cost of equity (and cost of debt) used in a WACC calculation must be
not only business risk but and financial risk introduced by the use of debt. consistent with the weights used. If looking at comparable companies,
also financial risk. check to see if they have similar capital structures. One technique is to
compute WACCs for each company. Another approach tries to unlever
costs of equity to adjust for financial risk. The first approach assures
numbers are consistent but doesn’t directly address differences in debt
policy. The second requires use of theoretical approximations.
Look to yields in debt In bond markets, yields to maturity and quotes on new issues (e.g. from Know your banker and debt markets well.
markets for cost of debt. banks or investment banks) provide forward-looking costs of debt.
Use a number of models Theoretical models are useful but not perfect in their application. Try different methods to estimate cost of equity. Look at how sensitive
and approaches to Assumptions and comparables are sometimes hard to specify exactly. your results are to those and your choice of comparables.
triangulate your estimate. See if your results are very sensitive to what appears to be reasonable
alternatives.
Be wary of false precision. Estimating costs of equity and weighted-average costs of capital involve Cost of capital estimates are approximate. Narrow your range, but don’t
many judgments and approximations. Your final estimate is subject to think you’ve got it exactly right.
those estimates.
Match cash flows and Increasingly, companies operate in many countries. If you are analyzing There are two basic approaches. One is to estimate a cost of capital for
discount rates in terms of cash flows denominated in a currency (say deutsche marks), one must each different currency, making sure to adjust for differential inflation
currencies. make sure that the cost of capital estimate reflects investor perceptions among currencies. The second is to translate cash flows to a common
of investments in that specific currency. currency using forecasted exchange rates and then use the common
currency for cost of capital.
Source: Created by author.