Mci Case

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1.What message is MCI trying to send to financial markets?

From 1993 until the start of 1995, MCI’s stock had outperformed the S&P. However, in 1995, the stock’s performance was poorer than the S&P. With shareholder’s getting restless, the idea of a stock repurchase was being considered. Depending on which option MCI chooses—stock repurchase with debt issuance or open market repurchase program—the message being sent could be different. Let’s consider option one—MCI issues debt and uses the proceeds to repurchase stock. According to the article “Raising Capital: Theory and Evidence” by Clifford Smith, the market would likely react very positively to this leverage-increasing event. Because of the information disparity between a company’s management and the financial markets, analysts believe a firm is more likely to repurchase stock if they feel it is undervalued. If MCI issues debt to finance a repurchase, they are implicitly making a statement that their stock is undervalued and they are better served with the tax or other benefits that additional leverage would provide. In addition, this option could be a signal to the financial markets that MCI is trying to change their capital structure to move closer to their minimum WACC. As we know, minimizing WACC will maximize a firm’s value. The second option, open market repurchase, would likely send the message that MCI feels the stock is undervalued. However, the price of the stock would not likely rise as much as it would under a fixed price or Dutch auction repurchase program due to the fact that there is so little regulation and disclosure behind the completion of the open market repurchase program. As we know, more positive, abnormal stock returns occur for fixed and Dutch auction repurchase programs where a company puts its “money where its mouth is.” Finally, the firm’s market-to-book ratio should be considered when determining the “believability” of undervaluation as the primary reason for the repurchase. As Ikenberry, Labonishok, and Vermaelan showed, only value stocks show consistent higher returns in the years following an open market repurchase announcement. Using the P/E ratio from Exhibit 2 as a proxy for market-to-book, we can see that MCI has a P/E ratio of 15.9, which is roughly the same as the average for the entire S&P. Therefore, it is safe to say that this is not a growth stock and thus, an open market purchase due to undervaluation is more credible.

2.What will be the effects of issuing $2B of new debt and using the proceeds to repurchase shares on: a.MCI’s shares outstanding
With a price of $27.75, MCI can purchase 72.07 million shares ($2 million / $27.75). That means the number of shares outstanding will decrease from 681 million to 608.93 million. Of course, there may be some flotation costs involved that would make the total amount of funds available to complete the repurchase less than $2 million, but since the case is silent about this, we are assuming these costs are negligible. b.MCI’s book value of equity

The debt-to-book value of equity for MCI is 0.412. Since long-term debt is $3,944 million before repurchase, that implies a book value of equity of $9,573 million, or $14.06 per share. After repurchase, the book value of equity decreases by $2 million to $7,573 million, or $12.44 per share. c.The price per share of MCI stock, and

Before the repurchase, there are 681 million shares outstanding at $27.75 for a market capitalization of $18,898 million. When MCI uses $2 billion to purchase 72.07 million shares at $27.75 each, the market capitalization decreases from $18,898 million to $16,898 million. However, the $2 billion decrease in market cap is partially offset by the value of the tax shield provided by the additional debt. Assuming debt is permanent, the additional present value of tax shields from issuing $2 billion in additional debt would be given by $2 billion x Tax Rate (40%)—or $800 million....
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