COURSE CODE: F-506

COURSE TITLE: CASES IN

CASE 11: FINANCIAL DECISION

MAKING
The MCI Takeover Battle:
Verizon V/S Qwest
 Submitted To
Dr. Gazi Mohammad Hasan Jamil
Associate Professor
Department of Finance
University Of Dhaka

Submitted By
Group No: 01
Section: A
MBA 21st Batch
Department of Finance
Faculty of Business Studies
University of Dhaka

Date of Submission: 3rdSeptember, 2020

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GROUP PROFILE

Serial Name MBA Roll No.

1. Aadeeba Khan Ahona 21- 907

2. Nusrat Janan Jeto 21-917

3. Umme Rumana 21- 921

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 LETTER OF TRANSMITTAL

September 03, 2020

Dr. Gazi Mohammad Hasan Jamil
Associate Professor
Department of Finance
University of Dhaka
Subject: Submission of a report on “MCI takeover Battle: Verizon V/S Qwest”

Sir,

It was a great opportunity to analyze a case of real financial problem and submission of an
individual report on ―MCI Takeover Battle: Verizon v/s Qwest‖ as part of the MBA programs
requirement for ―Cases in Financial Decision Making (F-506)‖ course. We have given utmost
effort for putting all relevant assumption and information in the preparation of this report as
informative and comprehensive one.

We are very pleased, grateful to you for the granting of this opportunity, and thankful to you for
your exclusive guidelines and assistance. As we have incorporated several assumptions, errors
may exist there and we are requesting your kind consideration in this regard.

Sincerely Yours,

Aadeeba Khan Ahona

On behalf of group No. 1
MBA 21st Batch, Section: A
Department of Finance
University of Dhaka

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 ACKNOWLEDGEMENT

This is high time we conveyed our deepest gratitude and sincere submission to the Almighty
ALLAH for giving us the opportunity to accomplish such an enjoyable task of preparing this
report in time.

We would like to pay our gratitude to all of the people who helped us a lot and for the
completion of this report before, during, and after the working period. At first we would like to
acknowledge the Almighty, who helped us every time and was with us and gave us moral
support and strength every moment.

We are especially grateful to our honorable course teacher, Dr. Gazi Mohammad Hasan Jamil,
Associate Professor Department of Finance, University of Dhaka for giving us valuable
suggestions and support to prepare this report. Without their advice and support, it would not be
possible for us to prepare this report.

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 EXECUTIVE SUMMARY
The report portrays a takeover battle between two companies Verizon and Qwest to acquire an
emerging firm MCI which has been survived after the bankruptcy file of WorldCom.
Considering the fairness opinion with specified offer terms from two bidders, MCI is concerned
about the wealth maximization of the shareholders being a merged firm with a key player of
telecommunication sector in the US. Although the offer terms declared a fancy piece of
negotiation by Qwest, MCI is considerate to the Verizon having lower bid price than another
bidder. The report analyzes the two options to be taken undertaking corporate level approach and
business level approach. Corporate level approach evaluated the value per share after merger
which declared the foremost benefit of MCI if it merges with it. Business level approach
evaluates demographic, strategic, synergic and product line analysis which also gives a positive
indication in favor of Verizon to merge with. But the scenario of merger with Verizon may
create possible hostile takeover threat by Qwest and regulatory burden as well. To defend the
hostile takeover from Qwest, the report suggest some possible precautions of MCI and the
company value after the merge with Verizon after undertaking the defensive strategies. These
defensive strategies include management buyout, dividend recapitalization, shareholder‘s support
and lobbing. The report also explains the possible risk of regulation and litigation in case of
merger with Verizon. At the final phase of the report, it suggests a favorable way of defense to
reduce takeover as well as regulatory burden by undertaking white squire or white knight
strategy.

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 Table of Contents
Chapter 1: Introduction ......................................................................................................................... 8
1.1 Origin of the Study ............................................................................................................................................. 8
1.2 Objectives of the Study .................................................................................................................................... 8
1.3 Scope of the Study .............................................................................................................................................. 8
1.4 Methodology of the Study.............................................................................................................................. 8
1.5 Data Analysis Tools ........................................................................................................................................... 9
1.6 Limitations .............................................................................................................................................................. 9
Chapter 2: Company Overview ............................................................................................................ 10
2.1 MCI ............................................................................................................................................................................. 10
2.2 Verizon.................................................................................................................................................................... 11
2.3 Qwest ....................................................................................................................................................................... 13
Chapter 3: Analysis of Industry ........................................................................................................... 14
3.1 Porter's Five Forces Model ........................................................................................................................ 14
3.2 Herfindahl-Hirschman Index(HHI) ..................................................................................................... 19
3.3 Key Success Factors in Telecommunications Industry .......................................................... 20
3.4 PESTLE Analysis ............................................................................................................................................... 21
1) Political: ................................................................................................................................ 23
2) Economic: ............................................................................................................................. 23
3) Social: ................................................................................................................................... 24
4) Technological: ...................................................................................................................... 24
5) Environmental: .................................................................................................................... 24
3.5 Relative Valuation ........................................................................................................................................... 25
Chapter 4: Company Analysis .............................................................................................................. 31
4.1 SWOT Analysis of MCI ................................................................................................................................... 31
4.2 Risk Analysis ....................................................................................................................................................... 32
Business Risk ................................................................................................................................ 32
Financial Risk ................................................................................................................................ 33
Bankruptcy Risk ............................................................................................................................. 34
4.3 Ratio Analysis..................................................................................................................................................... 35
Liquidity Ratio .............................................................................................................................. 35
Profitability Ratio .......................................................................................................................... 36
Leverage Ratio .............................................................................................................................. 37

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 Efficiency Ratio ............................................................................................................................. 38
4.4 Du-Pont Analysis .............................................................................................................................................. 38
Chapter 5: Problem Statement ............................................................................................................ 40
Chapter 6: Analyzing Merger Bids ....................................................................................................... 41
6.1 Business Unit Level Solution .................................................................................................................... 41
6.2 Corporate Level Evaluation ...................................................................................................................... 45
Chapter 7: The MCI Defenses: The Hostile Takeover of Qwest ........................................................... 50
7. 1 Takeover Defences by MCI .............................................................................................................................. 50
Management Buyout .................................................................................................................... 50
Dividend Recapitalization ............................................................................................................. 51
Shareholder’s Support .................................................................................................................. 52
Lobbing ........................................................................................................................................ 52
7.2 Potential Risks on the Decision of MCI ..................................................................................................... 52
Litigation ...................................................................................................................................... 52
Regulatory Restraints .................................................................................................................. 53
White Squire for MCI Takeover ................................................................................................. 53
CHAPTER 8: Conclution ....................................................................................................................... 55

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 Chapter 1: Introduction

1.1 Origin of the Study

As per the requirement of our M.B.A. program of the course F-506 (Cases in financial decision
making) this report has been prepared. We were assigned this report by our course instructor Dr.
Gazi Mohammad Hasan Jamil for nourishing and utilizing our theoretical knowledge by
implementing them into practical scenario. This will help us to improve our knowledge level on
how to solve real life business problems and deal with them.

1.2 Objectives of the Study

Our prime objective of this study is to successfully meet the requirements of our course and to
enrich our level of knowledge in solving business problems. Other associated objectives are-

 To derive knowledge regarding Merger and acquisition issues

 To find out the best possible financing sources
 To evaluate the possible sources of financing and find out the least costly source.
 To identify the alternative that can increase firm value
 To understand the various ways of finding proper offer price of an acquisition

1.3 Scope of the Study

In this study we tried our best to find out the solution for the company and provide alternative
solution if the prescribed one didn‘t worked after the analysis. Lastly we tried to provide some
recommended actions that will help the company to make better business decision.

1.4 Methodology of the Study

Data that have been used in this study have been taken from the case of ―The MCI Takeover
Battle: Verizon V/S Qwest‖. Besides we took help from our assigned textbook, suggestions

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given by our honorable course teacher. Finally for risk analysis and valuation we use different
mathematical tools.

1.5 Data Analysis Tools

For analysing the given information, we have used various valuation techniques and risk
analysislike FCFF, DuPont, Ratio Analysis, Degree of Operating Leverage (DOL) and Degree of
Financial Leverage (DFL).

1.6 Limitations

The major limitations encountered are as follows:

 It was quite difficult and challenging for us to complete the report efficiently, analyse the
riskiness of the projects and value the alternatives within the given time.
 We didn‘t find all the required information about the company so we had to assume
several points to complete the report.

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 Chapter 2: Company Overview

2.1 MCI
Originally founded as Microwave Communications in 1963, MCI was acquired by
WorldCom in 1998 The MCI Board favored the WorldCom bid, issuing a proxy statement
to its shareholders to solicit their support. But before the shareholder vote was complete, a
new suitor entered the fray—GTE, a leading U.S. local telephone company, submitted an
all-cash offer of $28 billion. WorldCom ultimately prevailed, paying $37 billion for MCI.
MCI provided a diverse range of communication products and services in over 200
countries. Its segments were organized by consumer group and included 1) business
markets (accounting for $14.1 billion of 2003 revenues of $27.3 billion), including medium
and large domestic and international businesses, plus government agencies; 2) mass
markets ($6.4 billion), including residential and small- business customers; and 3)
international ($3.9 billion), including businesses and government agencies outside the
United States. An additional $3 billion was generated through an ownership stake in
Embratel, a Brazilian voice and data company. MCI management reported: ―We operate
one of the most extensive communications networks in the world, comprising
approximately 100,000 route miles of network connections linking metropolitan centers and
various regions across North America, Europe, Asia, Latin America, the Middle East,
Africa and Australia.‖ Furthermore, the company owned ―one of the most extensive Internet
protocol backbones, and we are one of the largest carriers of international voice traffic.

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 2.2 Verizon
Verizon‘s lineage dated back to the incorporation of Bell Atlantic in 1983, one of seven ―Baby
Bells‖ formed from the breakup of AT&T. Bell Atlantic, which initially received phone-service
rights in six states and Washington, D.C., competed in a variety of communications businesses
including wireless, Internet, and directory publishing. Bell Atlantic expanded internationally in
the 1990s and doubled its size in 1997 with the $21 billion merger with NYNEX, based in New
York. In 2000, with the purchase of local phone company GTE, Verizon Communications was
formed.

Based in New York City, Verizon faced challenges in the wake of the 2001 terrorist attack,
reporting damage to its main offices next to the World Trade Center. In addition, the company
lost 11 cell sites in the area. The unexpected downturn in the telecom sector hit Verizon and its
competitors hard, with demand for many high-tech products and services falling precipitously.
In 2002 and 2003, the company carried out a series of divestitures aimed at reducing debt and
focusing operations on its core businesses.

Primarily serving U.S. markets, Verizon, which had 210,000 employees, was organized into
four main segments: domestic telecom (accounting for $39 billion out of $71 billion in total
revenue), domestic wireless ($28 billion in revenue from a customer base of 45.5 million),
information services ($3.6 billion), and international (just under $2 billion). Its domestic
telecom services, which included local and long-distance telephone services, Internet access,
digital-channel service, and inventory management systems for businesses, were supported by
roughly 145 million access lines in 29 American states. Verizon‘s domestic wireless segment,
which provided a variety of wireless voice and data services, grew out of a joint venture with
Vodafone Group. In the category, it was second only to Cingular Wireless in the United States.
(Other competitors included Nextel, Sprint, T-Mobile USA, ALLTEL, and US Cellular.) The
information services segment assisted customers with website creation and other electronic
publishing services, while Verizon‘s international segment, which extended the company‘s so-
called wireline and wireless services to Europe and the Americas, contributed just under $2
billion to revenue in 2004.

At year-end 2004, the roughly $400 billion telecommunications industry was experiencing
what Verizon executives termed a ―mega-trend in telecommunications—the shift from analog
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to digital technology, from wired to wireless platforms, and from narrowband to broadband
services.‖ In 2004, there were more long-distance calls made over wireless networks than
traditional wireline networks. More than 160 million Americans had wireless phones, with
roughly one in five using their mobile phone as the primary communications device. And more
than 70% of American households were connected to the Internet, increasingly via broadband
connections. Verizon identified its growth markets as 1) wireless, 2) broadband digital
subscriber line (DSL), and 3) wire line long-distance service in the consumer and enterprise
markets.

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 2.3 Qwest

Qwest entered into the telecommunications market through a series of mergers and acquisitions.
In 1993, the company joined forces with Southern Pacific Telecommunications Company (SPT),
launching a nationwide fiber-optic network.

Like many high-tech companies at the time, Qwest had invested heavily in new assets,
anticipating industry growth, and had to reduce its operations following the industry wide
drop in demand.

A firm of 41,000 employees, Qwest organized into three main segments of business: wire
line, wireless, and services. Unlike Verizon, whose core geographical region was the
Northeast, Qwest focused service coverage in 14 states in the American West and
Northwest. In 2004, the company earned $13.8 billion in revenue, with $13.2 billion
coming from its wire line segment.

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 Chapter 3: Analysis of Industry

In order to perform the industry analysis, we have analysed the fastest growing internet
companies industry using the Porter‘s Five Forces model. The industry analysis of MCI is given
below-

3.1 Porter's Five Forces Model

Porter's Five Forces Model helps strategic business managers analyse the industry in which their
companies operate to determine what can be done to get an advantage over their existing
competitors and also to determine how attractive a particular industry would be for new entrants.

Porter's Five Forces are: 1) Threats of entry posed by new or potential competitors; 2) Degree of
rivalry among existing firms; 3) Bargaining power of buyers; 4) Bargaining power of suppliers
and 5) Closeness of substitute products.

Figure 1: Porter's Five Forces model

In the below, an analysis of the fastest growing Internet company Industry using the above
named forces is provided.

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 1) Threats of entry posed by new or potential competitors

Prior to Mid-nineties, entry into fixed line telecom business was very difficult owing to several
factors, Firstly it was a very capital intensive industry, entry into this industry meant that the
firms needed access to huge amount of capital mainly to cover the fixed costs to lay and maintain
a physical network (exchanges, fiber optic cables etc) to the premises of customers. In addition
to that firms needed to get regulatory approval/licenses from the Federal Communications
Commission (FCC), which was both costly, and a tedious affair. Hence the companies in this
industry mostly tended to monopolies strictly regulated by the government subject to price
controls and moderate to heavy taxation. Deregulation and the telecom act of 1996 provided a
significant reduction in barriers as the new entrants did not need to own their networks. The
technological changes also provided impetus to the significant reduction of barriers; Internet
Telephony provided a way for several firms to enter the market and compete with the
incumbents without the significant upfront fixed costs. One of the notable entrants into the
business is Vonage; this firm began offering its version of IP telephony product since 2003. The
entry of new progressively become very easy, in fact it has become so easy that there are
companies like RTC Factory claim to provide services that can let firms start their own branded
fixed line IP telephony voice business within 6-8 weeks in 10 easy steps.

New entrants to the marketplace pose a very low threat to MCI. The cost of establishing a
wireless company and building a network that can compete with a low-budget carrier, much less
an industry behemoth such as MCI, is substantial. Additionally, a wireless service company
must navigate a labyrinth of government regulations before earning a dime. Even if a new player
can bear the cost and get past the regulations, next comes the process of building a brand name
that can compete. MCI has been around since the early days of the industry and has spent years
building its name. It is unlikely that a new company can arrive on the scene and clear the
necessary hurdles to compete with MCI.
2) Degree of rivalry among existing firms
Industry rivalry has become extremely intense with the emergence of new competing firms
leading to price cuts across the industry. Voice offerings are turning into commodities with the
business going to lowest cost provider.

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The threat of competition in the wireless industry is fierce. MCI's biggest and most longstanding
rival is AT&T. The typical customer profile for the two companies is similar, and AT&T claims
the highest market share in the industry behind MCI.

MCI's coverage network has been the strongest in the industry since at least the early 2000s, but
its competitors have invested much capital into catching up. The coverage difference between
MCI and its competitors is smaller than ever, and the gap could disappear completely within five
to 10 years as other companies add towers and advance their technologies.If this happens, MCI
must find a new way to set itself apart from its competitors.

3) Bargaining power of buyers

With increased choice of several technologies and means of communication available and
entrance of several new firms buyer power is been increasing. The consumer now has access to
several means of communication like email, instant messaging which are diminishing the
importance voice services. Residential consumer also benefits with local number portability (A
regulation from FCC which mandates the carriers to move the phone number when the customer
switches to a different carrier). This feature makes switching costs negligible. The business
segment however is prone to significant switching costs as they rely on more customized
products which are tailored to their businesses and most times are locked into long-term
contracts.

Buyers have significant bargaining power in the wireless industry. Switching carriers is easy and
inexpensive, and MCI's competitors constantly run promotions offering perks specifically to
customers who switch from MCI.

Customers can switch to another carrier within an hour or less while keeping the same phone
number and experiencing no service interruption. MCI must continue to give its customers
reasons to stay. Up to this point, the company has done so by touting its superior network and its
lower rates of dropped calls and texts. As these advantages wane, the company must seek a new
edge.

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 4) Bargaining power of suppliers

The Suppliers in this industry are the manufacturers of telephone switching /switch board
equipment, fiber optic cables, network equipment, and billing software makers. The prominent
names in this industry include Cisco, Alcatel-lucent, Nokia, Nortel, Motorola and Tellabs
etcAfter the deregulation of downstream service providers and the technological breakthrough in
IP networks, Telecom equipment makers began to ramp up manufacturing in order to meet the
huge anticipated demand, however aftermath the dot com bubble, demand did not pan out as
expected and led to overcapacity and eventually demise of several firms. The evidence of decline
can be gauged from the fact that the telecommunications industry Association (TIA) reported
that in 2001, a cumulative decline of $30.5 billion in revenues4 [Encyclopedia of American
Industries]. With excess capacity and falling demand, the suppliers have do not have the power
and clout to negotiate with the telecom behemoths. However with the demand in recent years has
started to pick up with fixed line providers deciding to install fiber based networks to provide
faster data and video services.

MCI's suppliers have little bargaining power and represent an insignificant threat to the
company. MCI calls on suppliers for products to help build and expand network infrastructure
and for components to manufacture physical products. The number of suppliers MCI has to
choose from is huge. By contrast, the number of companies as big and deep-pocketed as MCI
that these suppliers have the opportunity to do business with is not large. This asymmetry places
most of the leverage firmly in MCI's hands. MCI can negotiate from a position of power, and in
most cases, it can switch from one supplier to another without much trouble if necessary.

5) Closeness of substitute products.

Several substitute products and services have emerged to fixed line telephones as a result of
technological breakthroughs. Some of these are more convenient and offer far greater value to
the consumer and have diminished the importance of fixed line phones. Substitutes include IP
Telephony, Mobile phones, Satellite, Email, and Instant Messaging etc. Among the several
substitutes that have emerged, IP telephony has emerged as the biggest threat. Applications like
Skype have been extremely popular among younger generation users and are fast emerging as

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preferred means of communication. Wireless phones are also getting cheaper each year over the
last decade; this has provided consumers with more convenience and mobility, to the extent that
the younger demographic now considers a fixed line phone redundant.

The threat of substitutes is perhaps the biggest one MCI faces. The company would argue that
service from AT&T, T-Mobile, or Sprint is not a perfect substitute for MCI service, as these
companies offer less extensive coverage and, according to consumer surveys, inferior customer
service. However, the chasm is narrowing between MCI's network and those offered by
competitors, and lower prices are a constant looming temptation for MCI customers.

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 3.2 Herfindahl-Hirschman Index(HHI)

The Herfindahl-Hirschman Index (HHI) is a commonly accepted measure of

market concentration. It is calculated by squaring the market share of each firm competing in a
market or industry and then summing the resulting numbers.

Telecommunication Industry
HHI

Serial Market Market share * Market share ^

Companies Revenue
no. Share 100 2
1 AT&T 30537.00 14.35% 14.35 205.89
2 Century Tel 2410.90 1.13% 1.13 1.28
3 Frontier 2193.00 1.03% 1.03 1.06
4 Level 3 3712.00 1.74% 1.74 3.04
5 MCI 20658.00 9.71% 9.71 94.22
6 Qwest 13809.00 6.49% 6.49 42.10
7 SBC 40787.00 19.17% 19.17 367.31
8 Sprint 27428.00 12.89% 12.89 166.10
9 Verizon 71283.00 33.49% 33.49 1121.90
11 Total 212817.90 100.00% 100.00 2002.91
Low market
concentration Less than 1500
Moderate
concentration 1500 to 2500
Greater than
Highly concentration 2500

After calculating the HHI index the result is 2002.91 which is more than 1500. This result

indicates that the telecommunication industry is moderately concentrated.

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 3.3 Key Success Factors in Telecommunications Industry
 Bundling
Consumers value convenience more than anything else. A company‘s ability to provide multiple
services like wireline / wireless/ high speed internet / video at an attractive price not only
provides value to the consumer but also helps the company‘s bottom-line due to reduced
customer acquisition costs. It also is widely believed in the telecom industry and supported by
the data, that churn reduces drastically for customers subscribed to a bundle as a result of
increased switching costs.
 Network Quality
One of the key difference between the old generation PSTN (public switched telephone network)
used by telecom companies versus the new generation IP networks used by both the cable
providers and VoIP providers is the ability to receive phone calls on the PSTN networks when
the power is out. There is difference in quality of the voice transmitted, however the gap is
closing fast.

 Economies of scale
Telecom is a huge fixed cost business; most of the costs go into installing and maintaining the
network. The marginal cost of adding a new customer is very small. As a result, Providers with
large subscriber bases enjoy a significant advantage over the smaller ones.
 Customer Service
In this industry, although the customer contact with the firm is minimal, it is very critical and can
define customer experience. Customer mostly comes into contact with the employees of the firm
only during installation and service outages, the expectation of the customer is that the service be
always available and the problems be immediately fixed.
 Brand Name
Brand Name plays an important role for the customer choosing the service. In this Industry Bell
and Cable companies have been able to build brand recognition over time, VoIP
entrant however have to spend significant amount of money in advertising to be able to counter
these strong brand names.

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  Retail Presence
Wireless phone industry has required retail presence from traditional telecoms mainly to display
and sell wireless devices, this presence has helped them with customer as they were more
accessible to the customers and provided a new medium of distribution for all services, Cable
and VoIP firms however have to depend on electronic retailers.
 Financial Strength/Resources
With high fixed costs in this industry and frequent network up gradation and licensing costs, it is
essential for the firms in this industry to have a strong balance sheet. The ability to raise money
at cheaper rates compared to the competition provides a significant competitive advantage
 Convergence
Convergence is the ability for customers to access any data seamlessly without restrictions and
the networks and the devices to get to that data. In future the success of the telecom companies is
dependent on how effectively they can provide converged services.
 Partnerships
Diversity of services this industry makes it difficult for a service provider to be good at
everything, so the crucial thing for a firm in this industry is to be able to forge partnerships to be
able to provide what customers need.
 Data Speeds/Bandwidth
Explosive growth of internet has created content rich applications which require enormous
amount off bandwidth. The Service provider who has the biggest amount of bandwidth with the
last mile connectivity will have competitive advantage over the rest of the competition

3.4 PESTLE Analysis

PESTLE analysis, which is sometimes referred as PEST analysis, is a concept in marketing

principles. Moreover, this concept is used as a tool by companies to track the environment
they‘re operating in or are planning to launch a new project/product/service etc. PESTLE is a
short form which in its expanded form denotes P for Political, E for Economic, S for Social, T
for Technological, L for Legal and E for Environmental. It gives a bird‘s eye view of the whole
environment from many different angles that one wants to check and keep a track of while

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contemplating on a certain idea/plan. There are certain questions that one needs to ask while
conducting this analysis, which give them an idea of what things to keep in mind. They are:

 What is the political situation of the country and how can it affect the industry?
 What are the prevalent economic factors?
 How much importance does culture has in the market and what are its determinants?
 What technological innovations are likely to pop up and affect the market structure?
 Are there any current legislations that regulate the industry or can there be any change in
the legislations for the industry?
 What are the environmental concerns for the industry?
All the aspects of this technique are crucial for any industry a business might be in. More than
just understanding the market, this framework represents one of the vertebras of the backbone of
strategic management that not only defines what a company should do, but also accounts for an
organization‘s goals and the strategies stringed to them. It is very critical for one to understand
the complete depth of each of the letters of the PESTLE. It is as below:

Figure 2: Pestle Analysis

Here is a PESTLE analysis of the telecommunication industry.

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 1) Political:
The political environment is full of risks for the telecom sector. The traditional political risks for
telecom are the ones related to regulations, network licensing, national radio spectrums and in
case of certain nations trade barriers. Generally, these issues have affected the network operators
and the effect has been felt less by equipment and service providers. However, one factor that
worked in the favor of the telecom industry was privatization and deregulation. For some time,
the telecom industry enjoyed relative freedom based upon its importance in the process of
globalization. However, a number of threats have emerged in last some years that could mean
that political risks are on the rise again. However, the level of government control in these
markets is high.
Political risks rooted in national security and human rights issues are another major source of
political pressure for the telecom sector. Governments across the world have launched measures
to monitor and control communications motivated by political and security reasons. These
measures have grown tougher in the aftermath of the terrorist attacks in 2001 on US and hacking
attempts on the US government‘s databases. All these factors show that political risks are going
to sustain. Moreover, a large number of countries have maintained trade barriers against the US
telecom companies.

2) Economic:
The role of economic factors is just as important in the context of the telecom industry. The
recession had hurt this sector deeply. People were cutting back on their telecom spending during
the recession. Cutbacks on landlines had grown during the recession while the growth of cellular
services had slowed. Now since the economic recession has passed, consumer spending on
telecom is back on track. Globally, it all depends on the pocket of the consumer. The happier is
the economy, the higher will be consumer spending on any product or service. These economic
trends are also supported by technological changes. Fewer trade barriers could mean better
growth rate for the US based network providers.

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 3) Social:
Social factors also have a deep influence on the industry and its profitability. Connectivity is
central to so many things including work and entertainment. Globally, the use of internet based
services has grown. A higher number of people are using the social media for fun and business.
From YouTube videos to Netflix, video streaming services all require a very good connectivity.
Moreover, more and more people like to remain connected on the go. This is a part of their
lifestyle. For some it is because they are too busy with work and in case of others they cannot
remain disconnected with family and friends. Overall, these trends have proved highly favorable
for the telecom industry.

4) Technological:
The entire telecom industry is based on technology and therefore technological changes
influence it deeply. The use of mobile computing is on the rise. Around the world IT is changing
things like never before. It is central to several things including business and productivity.
Computers and cloud computing have become the core of productivity. It is the telecom sector
that stands to gain the most from these technological trends. Smartphone and tablet sales have
kept growing and none of the two can be used fully without a fast connection.
Autonomous driving too could become a reality in some years. This is just a part of the picture
because there are several other small and big technologies that will utilize a connection like
biometrics whose use on smartphones is expected to grow. IT is another area that is giving rise to
major opportunities for the telecom providers. From connected cars to smart homes and
businesses, wearable, smart cities, several things will have connectivity at their core. 5G is
expected to take things ahead by reducing costs for the providers and speeding up our
connections many times. Thus, technological forces are one of the most important ones affecting
the telecom industry.

5) Environmental:
Smartphones are a large part of the e-waste generated every year. In the light of the level of e-
waste generated by both service and equipment providers, the industry is focussing on waste
management and minimizing its environmental footprint. More and more providers are investing
in reducing their carbon intensity. Verizon is in the process of implementing its additional 24

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MW of Green energy by 2025. Since they make a direct contribution to the production of e-
waste, providers like Verizon are also devoted to device recycling. Through its program, it
rewards the consumers who recycle their devices rather than throwing them into waste. AT&T
has also invested in recycling.

6) Legal:
Globally legal compliance gives rise to big risks for the telecom providers. Apart from the
common labor and employment laws, there are several other laws and licenses that are essential
to be complied with. In US, the broadcasting regulations are overseen by the FCC which was
established by the Congress in 1934. There are several laws including those related to
telemarketing and privacy that the providers must comply with. Several changes took place in
the aftermath of the 9/11 attacks that gave rise to additional pressures for the telecom providers.

3.5 Relative Valuation

A relative valuation model is a business valuation method that compares a company's value to
that of its competitors or industry peers to assess the firm's financial worth. Relative valuation
models are an alternative to absolute value models, which try to determine a company's intrinsic
worth based on its estimated future free cash flows discounted to their present value, without any
reference to another company or industry average. Like absolute value models, investors may
use relative valuation models when determining whether a company's stock is a good buy.

1) Enterprise Multiple
Enterprise multiple, also known as the EV multiple, is a ratio used to determine the value of a
company. The enterprise multiple, which is enterprise value divided by earnings before interest,
taxes, depreciation, and amortization (EBITDA), looks at a company the way a potential acquirer
would by considering the company's debt. What's considered a "good" or "bad" enterprise
multiple will depend on the industry.

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Where:

 EV = Enterprise Value = Market capitalization + total debt - cash and cash equivalents.
 EBITDA is earnings before interest, taxes, depreciation, and amortization.

Investors mainly use a company's enterprise multiple to determine whether a company is

undervalued or overvalued. A low ratio relative to peers or historical averages indicates that a
company might be undervalued and a high ratio indicates that the company might be overvalued.

An enterprise multiple is useful for transnational comparisons because it ignores the distorting
effects of individual countries' taxation policies. It's also used to find
attractive takeover candidates since enterprise value includes debt and is a better metric
than market capitalization for merger and acquisition (M&A) purposes.

Enterprise value (EV) is a measure of the economic value of a company. It is frequently used to
determine the value of the business if it is acquired. It is considered to be a better valuation
measure for M&A than a market cap since it includes the debt an acquirer would have to assume
and the cash they'd receive.

2) Enterprise Value-to-Revenue Multiple (EV/R)

The enterprise value-to-revenue multiple (EV/R) is a measure of the value of a stock that
compares a company's enterprise value to its revenue. EV/R is one of several fundamental
indicators that investors use to determine whether a stock is priced fairly.

The EV/R multiple is also often used to determine a company's valuation in the case of a
potential acquisition. It‘s also called the enterprise value-to-sales multiple.

Generally used as a valuation multiple, the EV/R is often used during acquisitions. An acquirer
will use the EV/R multiple to determine an appropriate fair value. The enterprise value is used
because it adds debt and takes out cash, which an acquirer would take on and receive,
respectively.

EV/R=Revenue/Enterprise Value

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The EV/EBIT ratio is a very useful metric for market participants. A high ratio indicates that a
company‘s stock is overvalued. Such a situation, while beneficial for an immediate sale of
shares, can spell disaster when the market catches up and attaches the proper value to the
company, causing share prices to plummet.

Conversely, a low EV/EBIT ratio indicates that a company‘s stock is undervalued. It means that
share prices are lower than what is an accurate representation of the company‘s actual worth.
When the market finally attaches a more appropriate value to the business, share prices and the
company‘s bottom line should climb.

Ultimately, the lower the EV/EBIT, the more financially stable and secure a company is
considered to be. However, the EV/EBIT ratio can‘t be used in isolation. Analysts and investors
should use the ratio alongside others to get a full picture of a company‘s financial state and
actual worth, whether the market‘s interpretation of value is accurate, and how likely the market
is to correct for flawed valuation.

3) P/E Multiple

The Price Earnings Ratio (P/E Ratio) is the relationship between a company‘s stock price
and earnings per share (EPS). It is a popular ratio that gives investors a better sense of
the value of the company. The P/E ratio shows the expectations of the market and is the price
you must pay per unit of current earnings (or future earnings, as the case may be).

Earnings are important when valuing a company‘s stock because investors want to know how
profitable a company is and how profitable it will be in the future. Furthermore, if the company
doesn‘t grow and the current level of earnings remains constant, the P/E can be interpreted as the
number of years it will take for the company to pay back the amount paid for each share.

P/E = Stock Price Per Share / Earnings Per Share

Investors want to buy financially sound companies that offer a good return on investment (ROI).
Among the many ratios, the P/E is part of the research process for selecting stocks, because we

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can figure out whether we are paying a fair price. Similar companies within the same industry
are grouped together for comparison, regardless of the varying stock prices. Moreover, it‘s quick
and easy to use when we‘re trying to value a company using earnings. When a high or a low P/E
is found, we can quickly assess what kind of stock or company we are dealing with.

Companies with a high Price Earnings Ratio are often considered to be growth stocks. This
indicates a positive future performance, and investors have higher expectations for future
earnings growth and are willing to pay more for them. The downside to this is that growth stocks
are often higher in volatility and this puts a lot of pressure on companies to do more to justify
their higher valuation. For this reason, investing in growth stocks will more likely be seen as
a risky investment. Stocks with high P/E ratios can also be considered overvalued.

Companies with a low Price Earnings Ratio are often considered to be value stocks. It means
they are undervalued because their stock price trades lower relative to its fundamentals. This
mispricing will be a great bargain and will prompt investors to buy the stock before the market
corrects it. And when it does, investors make a profit as a result of a higher stock price.

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 P/E
Company names Share price Enterprise Value EBITDA EV/EBITDA Revenue EV/Revenue EPS Multiples
MCI 20.20 6884.92 2133.00 3.23 20658.00 0.33 -12.60 -1.60
AT&T 19.10 21674.26 2734.00 7.93 -6469.00 -3.35 -8.10 -2.36
Century Tel 35.50 7544.60 741.10 10.18 337.20 22.37 2.40 14.79
Frontier 13.80 8792.38 574.90 15.29 72.20 121.78 0.20 69.00
Level 3 3.40 6829.10 -200.00 -34.15 -458.00 -14.91 -0.70 -4.86
Qwest 4.40 23508.16 573.00 41.03 -1794.00 -13.10 -1.00 -4.40
SBC 25.80 111269.22 5901.00 18.86 5887.00 18.90 1.50 17.20
Sprint 24.90 49305.52 3414.00 14.44 -1012.00 -48.72 -0.70 -35.57
Verizon 40.50 146892.85 13941.00 10.54 7831.00 18.76 2.60 15.58

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Company with low enterprise multiple can be considered a good take-over candidate. MCI‘s
enterprise multiple is 3.23 & it is undervalued. So Verizon & Qwest want to go to merger &
acquisition with MCI.

Company with lower EV/Revenue is considered good investment opportunity for Investors
because when EV/Revenue ratio is lower it is perceived as undervalued . MCI‘s EV/Revenue
is .33 which is good for the acquirer company.

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 Chapter 4: Company Analysis

4.1 SWOT Analysis of MCI

SWOT analysis helps to evaluate firm‘s current and potential position by examining
internally and externally. Here we have executed the SWOT analysis to find out MCI
Company‘s major strengths, weakness, opportunities & threats.

Strengths Weaknesses
strong international presence with products falling revenues (impairment charges)
and services in over 200 countries, mass
markets, international markets (business
and agencies outside US)

well-established customer base that technology displacement (aging technology)

includes 65% of Fortune 1000 companies and competition.
and 75 government agencies
well-established infrastructure, including reputational concerns due to negative net
100,000 route miles of network connections income
linking regions globally, internet protocol
backbone, carrier of international voice
traffic
Opportunities Threats
Focus on expansion of technological Huge Competition
advancement
Investment in online format (wireless, No expertise in wireless service, instant
Broadband digital subscriber line DSL, messaging and broadband connection
wireline long distance service)

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4.2 Risk Analysis
We have conducted four risk factors here such as business risk, financial risk, credit risk or
bankruptcy risk and country risk. Following discussion gives the thorough analysis of MCI‘s
risk.

Business Risk
Uncertainty of operating income is caused by the firm‘s industry.

Sales Volatility: It shows the extent of variability in relation to mean of the population.

Volatility of sales = f (Coefficient of Variation of Sales)

The Coefficient of Variation (CV) is defined as the ratio of the standard deviation σ to the
Mean µ:

CV =

Following chart shows the sales variability of the MCI Company of last two years.

Sales Variability
Particulars 2003 2004
Revenue 27,315 20,658
Mean Revenue 23,987
Standard deviation of Revenue 4707
Revenue Variability (CV) 19.62%

Since the coefficient of variation of sales (.1962) is lower than .50 so the volatility of sales is
low. That‘s why business risk is low.

Earnings Volatility: It shows the extent of variability in relation to mean of the population.

Volatility of Cost of sales = f (Coefficient of Variation of Earnings)

The Coefficient of Variation (CV) is defined as the ratio of the standard deviation σ to the
Mean µ:

CV =

Following chart shows the earning variability of the MCI Company of last two years.

Variability in EBIT

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 Particulars 2003 2004
Income before income taxes and interest 908 209
Mean EBIT 558.50
Standard deviation of EBIT 494.27
Variability in EBIT (CV) 88.50%

Since the Coefficient of Variation of Earnings 88.5% which is higher than 50% that means
earning risk are high.

Degree of Operating Leverage Volatility: Earnings variability of the MCI Company of last
two years is:

Degree Of Operating Leverage

Year 2003 2004
EBIT
908 209
Change of EBIT -
0.76982
Revenue 27315 20658
Change of Revenue -24%
Operating leverage 3.16

Degree of Operating leverage 3.16

Financial Risk
Financial risk is an umbrella term for multiple types of risk associated with financing,
including financial transactions that include company loans in risk of default. The possibility
that shareholders will lose money when they invest in a company that has debt if the
company's cash flow proves to be inadequate to meet its financial obligations. When a
company uses debt financing, its creditors will be repaid before its shareholders if the
company becomes insolvent. Financial risk also refers to the possibility of a corporation or
government defaulting on its bonds, which would cause those bondholders to lose money. A
high proportion of debt indicates a risky investment.

Financial Risk
2003 2004
EBIT 908 209
EBT 590 136
DFL 1.54 1.54

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The degree of financial leverage for MCI is 1.54 in 2003 and 2004 which indicates a
moderately higher financial risk for the company. The DFL has remained same over the time
and the leverage is constant to above 1.

Bankruptcy Risk
Standard scores are also called z-values, z-scores, normal scores, and standardized variables.
They are most frequently used to compare an observation to a standard normal deviate,
though they can be defined without assumptions of normality. In statistics, the standard score
is the signed number of standard deviations by which the value of an observation or data
point is above the mean value of what is being observed or measured. Observed values above
the mean have positive standard scores, while values below the mean have negative standard
scores. The Altman Z-score is the output of a credit-strength test that helps gauge the
likelihood of bankruptcy for a publicly traded manufacturing company.

Risk Distribution
Z > 2.90 Safe Zone

1.81 < Z < 2.90 Gray Zone

Z < 1.81 Distress Zone

The Z-score is based on five key financial ratios that can be found and calculated from a
company's annual report. The calculation used to determine the Altman Z-score is as follows:
Z-Score = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 In this equation: X1 = Working
capital/total assets X2 = Retained earnings/total assets 28 X3 = Earnings before interest and
taxes (EBIT)/total assets X4 = Market value of equity/total liabilities X5 = Sales/total assets.

Year 2004
Working Capital 2890.00
Total Assets 17,060.00
X1 Working Capital/Total Assets 0.1694
Weight 1.20
Total 0.2033

Retained Earnings
X2 Retained Earnings/Total Assets 0.2330
Weight 1.40

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 Total 0.3261

EBIT 209.00
X3 EBIT/Total Assets 0.0123
Weight 3.30
Total 0.0404

Equity 4,230.00
Total long term debt 2956
Equity/Total Debt 1.43
Weight 0.60
X4 Total 0.8586

Sales 20658.00
Sales/Total Assets 1.21
Weight 0.998
X5 Total 1.2085

Altman Z SCORE 2.64

Gray
Zone

Default risk is in gray zone for MCI Company because it‘s Z Score is 2.64 which is between
1.81 and 2.90.

4.3 Ratio Analysis

A ratio analysis is a quantitative analysis of information contained in a company‘s financial
statements. Ratio analysis is used to evaluate various aspects of a company‘s operating and
financial performance such as its efficiency, liquidity, profitability and solvency.

Liquidity Ratio
Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety.
Three liquidity ratios are calculated here which are current ratio, quick ratio and cash ratio.

Liquidity Ratios MCI Qwest Verizon

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Current ratio Current Asset/Current Liabilities 1.47 0.98 0.84
Cash ratio Cash& cash equivalents/ Current Liabilities 0.89 0.41 0.20

Current Ratio: It is the ratio of current assets to current liabilities. The current ratio in 2004
is 1.47 means that MCI has its current liabilities covered 1.47 times over. But due to limited
information, no trend is found here.
Cash Ratio: It is the ratio of cash to current liabilities. It relates the firm‘s cash and short-
term marketable securities to its current liabilities. The cash ratio is 0.89 in 2004.

1.60
1.40
1.20
1.00
0.80 Current ratio
0.60 Cash ratio
0.40
0.20
0.00
MCI Qwest Verizon

Here, cash and current ratios are higher in case of Qwest than Verizon. This liquidity ratio
gives better result for Qwest.

Profitability Ratio
These ratios are the way to measure financial performance of the company. Higher ratio
indicates that company is doing well.

Profitability Ratios MCI Qwest Verizon

Operating Profit Margin EBIT/ Revenue 0.01 0.04 0.20
Net Profit Margin NI/ Revenue -0.19 -0.13 0.11
Basic Earnings Power Ratio EBIT/TA 0.01 0.02 0.08
Return on Total Assets (ROA) NI/TA -0.23 -0.07 0.05
Return on Equity (ROE) NI/Equity -0.95 0.69 0.21
Operating profit margin and basic earning power ratio are positive only among the five
calculated values. Return on equity, return on total assets and net profit margin show negative
values and indicate poor performance, for that MCI is going to be bankrupt.

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 0.80
0.60
0.40
0.20
0.00 MCI
EBIT/ NI/ Revenue EBIT/TA NI/TA NI/Equity
-0.20 Qwest
Revenue
-0.40 Verizon
Operating Net Profit Basic Return on Return on
-0.60 Profit Margin Earnings Total Assets Equity (ROE)
Margin Power Ratio (ROA)
-0.80
-1.00
-1.20

Net profit margin and ROA are negative for Qwest, but all the profitability ratios are better in
case of Verizon.

Leverage Ratio

Solvency ratios measure a firm‘s long-term ability to meet its obligation or more generally its
financial obligations.

Leverage Ratios MCI Qwest Verizon

Debt Ratio TL/TA 0.75 1.11 0.77
Debt-to-Equity TL/Equity 3.03 -10.31 3.42
Long term debt ratio Long term debt/TA 0.35 0.69 0.21
Equity Multiplier TA/TE 4.03 -9.31 4.42

Total Debt Ratio: It is the ratio of total debt to total assets. The total debt ratio of 2004 is
0.75 means that the company used 75% debt to finance its total assets.
Debt-to-Equity Ratio: It is the ratio of total debt to total equity. The D/E ratio in 2004 is
3.03 means that debt is 303% of equity. Financial risk is moderately high as the leverage ratio
is high.

6.00
4.00
2.00
0.00
TL/TA TL/Equity Long term TA/TE MCI
-2.00
debt/TA Qwest
-4.00
Debt Ratio Debt-to- Long term Equity Verizon
-6.00 Equity debt ratio Multiplier
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-10.00
-12.00
Long Term Debt Ratio: Long term debt ratio is .3464 in 2004.

Equity Multiplier: Equity multiplier is 4.03 in 2004.

Debt ratios are reflecting shaky balance sheet of Qwest whereas Verizon is showing good
health of its financial position.

Efficiency Ratio
These ratios are used to measure whether the company is using its resources efficiently or
not.

Efficiency Ratios MCI Qwest Verizon

Total Asset Turnover Revenue/TA 1.21 0.57 0.43
Fixed asset turnover Revenue/Fixed Asset 2.59 0.69 0.49

Total assets turnover of 1.21 in 2004 indicates that the company can generate $1.21 of sales
against $1 expenditure in total assets. But the fixed assets turnover is 2.59.

3.00

2.50

2.00

1.50 Total Asset Turnover

Fixed asset turnover
1.00

0.50

0.00
MCI Qwest Verizon

In efficiency ratios, Verizon is performing less than Qwest .

4.4 Du-Pont Analysis

Du-Pont analysis is a method of performance measurement that was started by the DuPont
Corporation in 1920s. With this method, assets are measured at their gross book value rather
than at net book value in order to produce a higher return on equity (ROE). It is also known
as ―DuPont identity". DuPont analysis tells us that ROE is affected by three things:

o Operating efficiency, which is measured by profit margin

o Asset use efficiency, which is measured by total asset turnover

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 o Financial leverage, which is measured by the equity multiplier
According to DuPont analysis, ROE is affected by three things: operating efficiency, which is
measured by profit margin; asset use efficiency, which is measured by total asset turnover;
and financial leverage, which is measured by the equity multiplier. Therefore, DuPont
analysis is represented in mathematical form by the following calculation:

ROE = Profit Margin x Asset Turnover Ratio x Equity Multiplier

DuPont analysis breaks ROE into its constituent components to determine which of these
components is most responsible for changes in ROE

DUPONT ANALYSIS
ROE= net income/ equity= (Net profit margin*Asset turnover
ratio*Equity Multipiler)
2004
Net Profit Margin (NI/revenue) -19.37%
Asset Turnover Ratio (Revenue/TA) 1.21
Equity Multiplier (TA/TE) 4.03
ROE -94.61%

The ROE of MCI in 2004 is negative 94.61%. From the DuPont analysis we can see that the
decrease in ROE was mostly due to decrease in Net Profit Margin. DuPont analysis breaks
ROE into its constituent components to determine which of these components is most
responsible for changes in ROE.

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 Chapter 5: Problem Statement

This case is about the merger of MCI with Qwest and Verizon. There seemed to be a tough
competition in the industry which pushed MCI to merge with any of the two most suitable
companies that can result in greater synergies respectively. There was an intense bidding war
between GTE, British Telecom and World Com but later on the merger of MCI-WorldCom
took place.

MCI faced losses in 2004 therefore; it is now trying to recover those losses by performing
with either Verizon or Qwest. Even if WorldCom faced bankruptcy issues, it was able to
merge with MCI. MCI has a vast network and it has coverage in most of the areas and it
performed quite well already so WorldCom after getting merged with MCI made many major
acquisitions.

However, now it is considering boosting its profits so the directors will have to make a better
decision which should primarily act in the best interest of shareholders respectively because
of the fiduciary relationship between managers and the share owners. Apart from that, the
price that was offered by WorldCom for MCI was $27 billion. It was because WorldCom was
not willing to let other competitors to takeover MCI so it made a counter-bid as a result the
price being offered by US domestic telephone company.

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 Chapter 6: Analyzing Merger Bids

MCI has received two proposals of merger which are needed to be appropriately evaluated
from two different perspectives. It is necessary to understand the profitability and after
merger effect on share price of two companies as the corporate level approach. Another
approach indicates the business level evaluation that reveals the compatibility of the business
nature, core service and strategic choices of the target company upon which the merger bids
will be evaluated.

6.1 Business Unit Level Solution

Here remains tough competition in the industry which forced MCI (target) to merge with any
of the two most suitable companies that can result in protecting the losses and bringing
greater synergies respectively. There came an intense bidding war between GTE, British
Telecom and World Com but later on the merger of MCI-WorldCom took place. MCI faced
losses in 2004 but it is now trying to recover those losses by performing with either Verizon
or Qwest. MCI has a vast network and it has coverage in most of the areas and it performed
quite well already so WorldCom after getting merged with MCI made many major
acquisitions.

To evaluate this merger with two major competitors; Verizon and Qwest, a business unit
level analysis is mandatory. The price that has been offered by Qwest i.e. $8.4 billion is
higher than the bid price offered by Verizon which is $7.6 billion. On the other hand, Verizon
has made a quite a huge market in Wireless sector as compared to the Qwest which mainly
focuses on wire line and even generating high revenues. However, if it wants to remain in
competition, then it will have to switch its focus from wire line to wireless consumers
because of the rapid growth in technology nowadays and apart from that technology plays a
most important role in the success of company.

Demographic perspective

Despite the technology, if both the competitors are considered demographically, then Verizon
is actually way ahead from Qwest. Though Verizon has a significant lack of international
presence, as suggested by under $2 billion in international revenue (2.8% of the total rev.),
Verizon has mainly made its huge customer base in Northeast and Qwest was on the other
able to make its presence viable in Northwest and West respectively. Also, it should be kept
in mind that the western areas less populated and mostly there are landline users rather than

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the wireless users. However, Verizon is able to manage even a huge population in Northeast
where the percentage of wireless customers is high. Therefore, Qwest has to make a huge
investment in wireless equipments respectively if it wants to win the merger.

Economic perspective

Considering economic perspective, it is seen that the telecom industry was affected extremely
by the 2001 terrorist activities. As a result, the demand for technological products has also
reduced. Despite this, there is a change in thinking of the customers also because they need
everything as a single package. Therefore, by keeping the needs of customers in mind
Verizon and Qwest should consider different ways in order to make their services much
better and on the other hand MCI should also decide between two companies with which it
will want to merge. Hence both of the companies have to take into account the socio-cultural
issues respectively in order to make their image attractive to MCI.

Financial Position

MCI has a low debt and it is able to make the future prospects of Qwest even if it is having an
insecure financial statements. On the other hand, Verizon is trying to lessen its debt amount
which hinders its improvement.

Particulars MCI Qwest Verizon

Short-term debt 24 596 3,593.00
Long-term debt 5,909.00 16,690.00 35,674.00

On the other hand, if the share price of Verizon is compared with Qwest then Verizon is
having quite a high share price of $34.86/share and Qwest $3.79/share only. Also, in case of
Verizon, bad timing with investments in new assets, for an anticipated industry growth that
didn‘t materialize, led to high debt levels and need to sell assets for liquidity. Simultaneously,
industry decline led to weak sales, which together, led to reductions in operations.

Product perspective

Verizon‘s domestic wireless segment, which provided a variety of wireless voice and
data services, grew out of a joint venture with Vodafone Group. The information services
segment assisted customers with website creation and other electronic publishing services,

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while Verizon‘s international segment, which extended the company‘s so-called wireline
and wireless services to Europe and the Americas, contributed just under $2 billion to
revenue in 2004. At year-end 2004, now telecommunications industry is experiencing ‗mega-
trend‘— the shift from analog to digital technology, from wired to wireless platforms, and
from narrowband to broadband services.‖ In 2004, there were more long-distance calls made
over wireless networks than traditional wire line networks. More than 160 million Americans
had wireless phones, with roughly one in five using their mobile phone as the primary
communications device. And more than 70% of American households were connected
to the Internet, increasingly via broadband connections. Verizon identified its growth
markets as 1) wireless, 2) broadband digital subscriber line (DSL), and 3) wireline
long-distance service in the consumer and enterprise markets.

Profitability Ratios MCI Qwest Verizon

Operating Profit Margin EBIT/ Revenue 0.01 0.04 0.20
Net Profit Margin NI/ Revenue -0.19 -0.13 0.11
Basic Earnings Power Ratio EBIT/TA 0.01 0.02 0.08
Return on Total Assets (ROA) NI/TA -0.23 -0.07 0.05
Return on Equity (ROE) NI/Equity -0.95 0.69 0.21

One large shareholder indicated that the Qwest offer ―represents not only a superior short-
term financial value, but exceptional long-term value as well.‖ In addition, a number of hedge
funds with financial interests in MCI expressed public support of a merger with Qwest. One
arbitrageur stated plainly: ―We want the highest price. But then we are on our way as soon as
the deal closes.‖ Among analysts and industry observers, a range of opinions emerged:
―Verizon has a signed agreement with MCI and a proven track record of completing
transactions that create value for shareholders, customers, and employees.‖ ―The [MCI] board
will have to choose how much to listen to hedge funds and arbitrageurs, who have increased
their stakes in MCI in recent weeks and are pressuring the company‘s top managers and the
board to seriously consider Qwest‘s offer, in an effort to make a quick profit.‖ ―The
board is taking a risk by making assumptions about the future value of the Qwest stock that
aren‘t already built into the stock today. The market is efficient and Qwest‘s weakness is
already reflected in the stock. Cash is king in this game.‖ A firm of 41,000 employees,

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Qwest organized into three main segments of business: wireline, wireless, and services.
Unlike Verizon, whose core geographical region was the Northeast, Qwest focused
service coverage in 14 states in the American West and Northwest. In 2004, the
company earned $13.8 billion in revenue, with $13.2 billion coming from its wireline
segment. In its 2004 annual report, management outlined the following business trends:
Industry competition is based primarily on pricing, packaging of services and features,
quality of service, and increasingly meeting customer care needs. They expect technology
substitution such as wireless substitution for wireline telephones.

Market Coverage Perspective

The bids came at a time of intense industry consolidation during which companies that
survived the telecom downturn were reshaping the industry into ―a handful of full-
service giants.‖ MCI has a strong international presence with products and services in over
200 countries. Specifically, it has a strong presence in business ($14.1 b of $27.3 b total rev.),
mass markets ($6.4 b rev.), and international markets ($3.9 b). Additionally, MCI has a well-
established infrastructure, including 100,000 route miles of network connections linking
regions globally, and a well-established customer base that includes 65% of Fortune 1000
companies and 75 government agencies. Post-bankruptcy, MCI also has low debt levels.
Lastly, MCI has a strong internet protocol backbone and is one of the largest international
voice carriers. MCI only need scope and initiation of wireless and broadband digital
subscriber line (DSL) which exists only in the operational activities of Verizon. In line with
that discussion, Verizon is currently overcoming the bad impacts of 2001 terrorist attack. In
addition, the company lost 11 cell sites in the area. The unexpected downturn in the telecom
sector hit Verizon and its competitors hard, with demand for many high-tech products and
services falling precipitously. Primarily serving U.S. markets, Verizon, which had 210,000
employees, was organized into four main segments: domestic telecom (accounting for $39
billion out of $71 billion in total revenue), domestic wireless ($28 billion in revenue from
a customer base of 45.5 million), information services ($3.6 billion), and international (just
under $2 billion). Its domestic telecom services, which included local and long-distance
telephone services, Internet access, digital-channel service, and inventory management
systems for businesses, were supported by roughly 145 million access lines in 29
American states.

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The synergy between MCI, Verizon and Qwest

Verizon brings a strong domestic market presence to MCI‘s global presence. Thus, the two
companies together will be competitive on a global scale – backed by their large combined
customer base. Verizon also has strong financials, with the cash to invest in technologies such
as wireless technology, an area highlighted by both companies as a growth opportunity.
Qwest brings a domestic market to MCI‘s global presence in 200 countries. Qwest will also
benefit from MCI‘s post-bankruptcy balance sheet, which has significantly lowered debt-
levels. The combined entity would also have significant tax shields due to loss carry
forwards.

6.2 Corporate Level Evaluation

Corporate level evaluation identifies the quantitative nature of the business in light of
profitability, solvency, and after merger financial condition as well. It analyses the free cash
flow model valuation to determine the value of the company in stand-alone basis and in
combination with two other bidders. To calculate the stand-alone value of MCI, weighted
average cost of capital is determined.

Market risk premium 3.28%

Inflation risk premium 2.68%
Financial risk premium 2.50%
Country risk 1%
Business Risk 2%
Financial distress premium 0.5%
Cost of Equity 16.6%
Cost of Debt 7.24%
Tax rate 35%
After Tax Cost of Debt 4.71%
Equity 4,230
Debt 5,933
Total E & D 10,163
Weight of Equity 41.62%
Weight of Debt 58.38%
WACC 9.6%
Table: Assumptions and calculations of weighted average cost of capital of MCI

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The United States is a favorable business region for telecommunication services the country
risk index point gives one index point out of seven for doing business for which country risk
is taken as a lower percentage. Market risk premium is taken from the world market risk
premium meter and inflation risk premium is evaluated using the CPI of 2005. Undertaking
the financial, distress and business risk premium, cost of equity of MCI is calculated 16.6%
and the after tax cost of debt is 4.71%. Weighted average cost of capital for MCI is 9.6% as a
stand-alone basis. Using 1% terminal growth rate of MCI, and tax rate of 35%, the company
generates $17.11 value per share with enterprise of $5898.25 million. Following table shows
the summarized free cash flow valuation result of MCI.

In Million Dollars
Enterprise value 5898.25
Debt 5933.00
Cash 5504.00
Equity 5469.25
Number of Outstanding Share 319.60
Value Per Share 17.11
Table: Free cash flow valuation model synopsis of MCI

Merger with Verizon

A thorough analysis is conducted to understand the suitable merger bid for MCI. Using the
bidding quotes and other terms and conditions, after merger condition is calculated in this
portion. After the merger with Verizon, MCI will be able to boost up its revenue assuming
4% for the preceding years and 5% decrease in the operating expenses due to economies of
scale. Also a 5% decrease in the capital expenditures is taken into consideration. At the event
of merger with Verizon, the combined firms will be able to have a better growth rate of 2%
with a weighted average cost rate of 8.42%. Thus the value per share for MCI and Verizon
will be $50.33 and $53.45 respectively. Assuming a transaction cost of $3500 million, net
synergy for MCI is calculated $8458.65 million.

Synergy Calculation 2005E 2006E 2007E 2008E 2009E 2010E Terminal

Value
Revenue 720 640 600 580 568 564
Operating Expense 795 715 675 650 640 620

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Tax Reduction -212 -296 -306 -426 -432 -110
Capital Expenditures 50 50 50 50 50 100
Total 1,353 1,109 1,019 854 826 1,174 11,490.27
PV of Synergistic 1,248 943 799 618 552 723 7,075
Benefit
Total Synergies 11,959
Transaction Costs 3500
Net Benefit $8,458.65
Table: Calculations of synergies of MCI after merging with Verizon

With an exchange ratio of .4062, Verizon needs to issue 130 new shares which ultimately
makes the Verizon‘s total number of shares 2900. The calculation of new shares includes the
offer tem of $8.75 in cash and $14.72 in stock. Following table shows the combined value of
merger between MCI and Verizon.

FCF Valuation After Merger In Million Dollars

Value of MCI 5469.25
Value of Verizon 148038.93
Synergy $11,958.65
Transaction Cost 3500
Cash Required 2,796.50
Revised No. of Shares 2,899.5
Value per Share $ 54.90
Table: Combined values after merger between MCI and Verizon

Merger with Qwest

Using the bidding quotes and other terms and conditions, after merger with Qwest condition
is calculated in this portion. After the merger with Qwest, MCI will be able to boost up its
revenue assuming 3% for the preceding years and 4% decrease in the operating expenses due
to economies of scale. Also a 2% decrease in the capital expenditures is taken into
consideration. At the event of merger with Verizon, the combined firms will be able to have a
better growth rate of 2% with a weighted average cost rate of 5.61%. Thus the value per share
for MCI and Qwest will be $41.43 and $11.68 respectively. Assuming a transaction cost of
$3000 million, net synergy for MCI is calculated $7080.63 million.

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Synergy Calculation 2005E 2006E 2007E 2008E 2009E 2010E Terminal
Value
Revenue 540 480 450 435 426 423
Operating Expense 636 572 540 520 512 496
Tax Reduction -94 -190 -207 -330 -337 -110
Capital Expenditures 20 20 20 20 20 20
Total 1,102 882 804 645 621 829 8,289.21
PV of Synergistic 1,044 791 682 519 473 598 5,975
Benefit
Total Synergies 10,081
Transaction Costs 3000
Net Benefit $7,080.63
Table: Calculations of synergies of MCI after merging with Qwest

With an exchange ratio of .94, Qwest needs to issue 300 new shares which ultimately makes
the Qwest‘s total number of shares 2117. The calculation of new shares includes the offer tem
of $10.50 in cash and $15.50 in stock. Following table shows the combined value of merger
between MCI and Qwest.

FCF Valuation After Merger In Million Dollars

Value of MCI 5469.25
Value of Qwest 22350.93
Synergy 10,080.63
Transaction Cost 3000
Excess return 14%
Cash Required 3,355.80
Revised No. of Shares 2,116.87
Value per Share $14.90
Table: Combined values after merger between MCI and Qwest

After merging with Qwest, the companies will be able to generate only $14.90 value per
share which is significantly low from the after merger value per share with Verizon. Since
MCI is concerned about the maximization of shareholder‘s wealth, valuation indicates to
merge with Verizon for a shareholder‘s financial benefit.

Observing Corporate Structure

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With 45% stock volatility, Qwest offered for a takeover of MCI while 19% of stock volatility
is observed in the Verizon‘s stock. Such condition also supported the situation of MCI to take
a decision to merge with Verizon. Verizon and MCI, both of the firms pays dividend to keep
the attractiveness of the firm to the investors while Qwest pays no dividend. Both MCI and
Verizon provide inherent fidelity to the investors to the financial state of the company paying
dividends. Qwest is a high debt firm with a negative equity value which makes the debt to
equity ratio at -10.31. MCI being a high leveraged company, trying to reduce its debt at a
very lower level. At the same time, Verizon is also concerned about its core business revenue
rather than debt issuance. Being already a high leveraged firm with 3.03 debt to equity ratio,
it will be wise for MCI to merge with Verizon, however Verizon also possesses a significant
level of debt. MCI will have a good opportunity to convert its bond rating from B to A+ since
the proven records reveals that Verizon contains A+ rating bonds. Due the decreased
operating revenue by $4 billion in 2004, the company is concentrating in the core business
revenue which MCI to merge with Verizon with 20% operating profit margin while Qwest
generated only 4%. In case of profitability, Verizon come a step ahead of Qwest. But Qwest
holds a good base for meeting debt obligation than Verizon since it possesses 98 cents of
current asset against $1 debt.

Observing Industry Structure

Since all the three companies are active players in telecommunication industry of the United
States, the merger will turn into a horizontal integration while business organizations with
same service are going to merge. In case of horizontal merger, the target company wants to
have a good market positioned firm as the acquirer. From HHI analysis, it is observed that,
Verizon contains 33% of the market share which is the highest among all the market players
in that sector. Compared to that, Qwest contains only 6.5% of the market shares. In such
situation, it will be wise to take a horizontal merger with a supreme market player of the
sector.

All these corporate issues made the financial risk of Qwest higher along with the financial
distress costs. If MCI wants to recover its operating losses, generate more value to the firm,
merger with Verizon would be a suitable option for it.

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 Chapter 7: The MCI Defenses: The Hostile Takeover of
Qwest

While the analysts and board of MCI is thinking about the merger with Verizon with a lower
offer, Qwest declared its discontent on the way of conduct and information disbursement to
the interested parties. A possible scenario can be faced by MCI to accept a hostile takeover of
Qwest through hostile tender offer to the shareholders. As long as shareholders are eager to
have a good value from the merger bids, hostile tender offer may turn into an appropriate
strategy for Qwest. Although Verizon‘s merger offer declared a lower bid than Qwest which
eventually create the discontent to the shareholders of MCI, the company gives a good value
to the firm in combination. Possible defensive strategies can be taken by MCI to overcome
hostile takeover.

7. 1 Takeover Defences by MCI

Management Buyout
Management buyout (MBO) is a transaction where a company‘s management team purchases
the shares from the stockholders of the firm with a motive to reduce shareholder‘s control in
the takeover decision. While Qwest is trying to give a tender offer to the shareholders of MCI
to purchase majority of the shares at a premium price, management of MCI will offer the
premium price to the shareholders of MCI to purchase from them. It can facilitate MCI to
reduce the control of shareholders in the takeover decision wince the shareholding portion
will mostly go to the management. It is also seemed as the stock ownership of the
management. After MBO strategy taken by the firm, MCI will be able to reduce the salaries
of management which will eventually decrease operating cost by 10%. The value per share
for MCI with boost up at $56.15 which is a premium price for shareholders to sell their
holdings to the management. As a result of MBO, MCI will have the following values for the
company.

In Million Dollars
Enterprise value 16375.75
Debt 5933.00
Cash 7504.00
Equity 17947
Number of Outstanding Share 319.60
Value Per Share 56.15
Table: MCI value after undertaking MBO strategy

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In this situation, if MCI merges with Verizon it will be able to generate $59.60 value per
share as a whole.

FCF Valuation After Merger In Million

Dollars
Value of MCI 17946.75
Value of Verizon 148038.93
Synergy 11,958.65
Transaction Cost 3500
Cash Required 2,796.50
Revised No. of Shares 2,880.12
Value per Share 59.60
Table: Combined value of merger with Verizon after undertaking MBO strategy

Dividend Recapitalization
A dividend recapitalization is a type of leveraged recapitalization in which a payment is made
to shareholders. As opposed to a typical dividend which is paid regularly from the company's
earnings, a dividend recapitalization occurs when a company raises debt issuing bonds or
notes. To restrict the hostile takeover, target firms usually use this strategy as a defensive
measure of the hostile takeover making the firm unattractive. MCI may use this strategy by
issuing additional notes to pay cash dividend to the existing shareholders. In such process, the
dividend payment using debt will increase MCI‘s use of leverage and thereby decreases the
attractiveness to the acquiring firm. Value per share substantially reduces using this strategy.
As a result of dividend recapitalization, MCI will have the following values for the company.

In Million Dollars
Enterprise value 5215.42
Debt 6333.00
Cash 5504.00
Equity 4386.42
Number of Outstanding Share 319.60
Value Per Share 13.72
Table: MCI value after undertaking dividend recapitalization strategy

In this situation, if MCI merges with Verizon it will be able to generate $59.60 value per
share as a whole.

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FCF Valuation After Merger In Million
Dollars
Value of MCI 4386.42
Value of Verizon 148038.93
Synergy 11,958.65
Transaction Cost 3500
Cash Required 2,796.50
Revised No. of Shares 2,894.43
Value per Share 54.62
Table: Combined value of merger with Verizon after undertaking dividend recapitalization
strategy

Shareholder’s Support
To overcome a hostile tender offer to the shareholders, MCI will need to organize frequent
engagement with the shareholders. Since the company‘s 75% of the shareholders are
institutional, MCI need to maintain current shareholders‘ support by sending special requests
or by organizing the meetings with the most important shareholders.

Lobbing
Lobbying is a strategic action against the hostile takeover of firm. Organizing the media
campaign against a hostile takeover is called lobbing. In such case MCI will be able to have a
legislative action to protect itself from hostile takeover attempt.

7.2 Potential Risks on the Decision of MCI

Considering all the factors both corporate and financial levels of the bidders, MCI is
suggested to merge with Verizon which keeps its objective intact, makes a profitable ground
for the business and ensures better value for the shareholders. After considering the offer,
along with the takeover effects, MCI may face some potential risks as well.

Litigation
When corporate fiduciaries fail to maximize shareholder value in negotiating corporate
transactions, shareholders can bring a direct class action to demand, among other things:
additional consideration or a higher price; more favorable deal terms; statutory appraisal
rights; the chance for other bidders to present superior offers; the disclosure of material
information to allow shareholders to make an informed decision on whether to vote in favor
of the deal. At the same time, the bidders may file lawsuits against the target company

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accusing the target‘s board for improper conduct. Both of these litigation pressure will be
likely for MCI since the statement of the shareholders and the CEO of Qwest are quite
relatable to this clause.

It may create a pressure to the board of MCI in accepting offers from the selected bidder.
However, the litigation process will incur additional expense for the bidder who will open the
lawsuit. Shareholders are to be exposed with the material information so that they can
understand the fair value decision of the board regarding the takeover battle.

Regulatory Restraints
In 2000, MCI was denied regulatory approval for a proposed acquisition of leading long-
distance provider Sprint, offering roughly $115 billion in stock and $14 billion in assumed
debt. Concern over the deal was widespread, with regulators from the European Union
warning that the deal could reduce or restrict competition by creating a dominant player in
high-speed global services. Ultimately it was the U.S. Justice Department that blocked the
proposed business combination, as U.S. antitrust authorities feared the resulting shift in
industry structure would place upward pressure on prices.

In 2005, when MCI will decide to merge with Verizon, a regulatory pressure may rise to
avoid the shift in the industry structure and upward pressure on price. Right now, the
telecommunication sector is moderately concentrated where 33% of the market share is
consumed by Verizon. If MCI is merged with Verizon, the industry will shift to the
concentration region where Verizon will have a dominant power on the prices. Observing this
phenomena, US justice department may give the restriction on the merger with Verizon to
resist market competitiveness as well.

The board of MCI needs to be aware of these potential risks to consider in its merger decision
and make possible alternative solutions whenever the situation comes. A White Squire
defense may work out for reducing these risks.

White Squire for MCI Takeover

White squire refers to an individual or an investor or a company that saves another company
from a hostile takeover. The White squire saves the target company by buying a stake in the
target company before a hostile company acquires it. While Qwest is trying to give a hostile
tender offer to the MCI, Verizon can act as a white squire with better offer terms. It can buy
some of the stake from the MCI to reduce the litigation process filed by Qwest. The objective
of Qwest‘s hostile takeover is to take control over MCI against the wishes of the current

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owners or management by using legal means. To avoid this advancement, a Verizon as a
white squire may take a substantial block of shares and ally with the current owners as the
majority shareholders in order to reduce the amount of shares available for purchase thereby
blocking Qwest from taking controlling power. To make Verizon as the White Squire, the
board of MCI needs to ensure two things for Verizon.

Seat on the Board Generous Dividend

But other companies such as AT&T, SBC and others can give a hand of White Knight with
better offer terms if MCI wants to merge with other rather than Qwest. In that case, MCI may
have a favorable situation for management and shareholders, however losing the
independence being acquired.

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 CHAPTER 8: Conclution

Takeover battle between two companies Verizon and Qwest to acquire an emerging firm
MCI which has been survived after the bankruptcy file of WorldCom. Considering the
fairness opinion with specified offer terms from two bidders, MCI is concerned about the
wealth maximization of the shareholders being a merged firm with a key player of
telecommunication sector in the US. Although the offer terms declared a fancy piece of
negotiation by Qwest, MCI is considerate to the Verizon having lower bid price than another
bidder. In Corporate level approach evaluated the value per share after merger which declared
the foremost benefit of MCI if it merges with it. Business level approach evaluates
demographic, strategic, synergic and product line analysis which also gives a positive
indication in favor of Verizon to merge with. But the scenario of merger with Verizon may
create possible hostile takeover threat by Qwest and regulatory burden as well. To defend the
hostile takeover from Qwest, the report suggest some possible precautions of MCI and the
company value after the merge with Verizon after undertaking the defensive strategies. These
defensive strategies include management buyout, dividend recapitalization, shareholder‘s
support and lobbing. The report also explains the possible risk of regulation and litigation in
case of merger with Verizon. At the final phase of the report, it suggests a favorable way of
defense to reduce takeover as well as regulatory burden by undertaking white squire or white
knight strategy.

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