McI Case Analysis

MCI

CASE ANALYSIS:

PRESENTED: THURSDAY JUNE 15, 2006

MCI

CASE ANALYSIS

INTRODUCTION

MCI is at a critical point in their company history. After going public in 1972 they experienced several years of operating losses. Then in 1974 the FCC ordered MCI's largest competitor AT&T to supply interconnection to MCI and the rest of the long distance market. With a more even playing field the opportunities to increase market share and revenue were significant. In order to maximize this opportunity MCI required capital. Their poor financial performance required them to use less traditional instruments to obtain financing. The capital acquired supported their growth until they reached a level of profitability in 1978. Subsequently they continued to increase their net income and the quality of their balance sheet. With continued prospects for growth tempered with some regulatory uncertainty they need to determine their optimal financial structure for the future.

CAPITAL REQUIREMENTS

MCI's capital requirements for the next 3 years are x,y and z. (see exhibit A). These values are based on a number of different assumptions. (See exhibit B). The forecast is not without a level of uncertainty. Specifically there are regulatory decisions where the outcome is not clear at this time. This could impact profit margin plus or minus seven percentage points. (See exhibit c)

CAPITAL STRUCTURE

MCI current capital structure is x% debt and y% equity. Their key ratios are a, b, and c. Comparing to other firms in the utilities industry they appear to be underutilizing (debt/equity). (See exhibit D). Referencing the forecast there is expected to be an x% annual increase in net income which would support an increase in (debt/equity) and keep ratios within the range of other firms in the industry(see exhibit E)

HISTORICAL FINANCING

Since going public in 1972 MCI has a number of different instruments to raise capital including common stock, convertible preferred stock, debenture, subordinated debenture and convertible subordinated debenture (see exhibit F). Essentially, MCI relied heavily on convertible debt. As their stock price rose, the debt was converted to equity. Jeremy Stein (1992) states that a "good firm will use convertibles because the firm's true value will be made known before the debt is due". Following Stein's observations, Jen, Choi, and Lee (1997) conclude that "convertible bond financing is an attractive alternative for companies that have large growth potential but find both conventional debt and equity financing very costly". MCI clearly had a vision for substantial growth. The MCI management saw an opportunity for financing that would result in issuing equity and leave the possibility open to acquiring more debt in the future, if needed.

The advantage to choosing a convertible bond for financing is that "they provide issuers with 'cheap' debt and allow them to sell equity at a premium over current value". Jen, Choi, Lee (1997).

Subsequent to their initial public offering in 1971 which raised $27,070,000 by issuing 6,000,000 shares MCI required additional capital in 1975. They were able to raise an additional $8,165,000 of capital by issuing 9,600,000 units of common stock at a price of $1.00 per share. To increase the attractiveness of the offer a 5 year warrant was attached which allowed for the purchase of additional shares of stock at an exercise price of $1.25. This was the best instrument to use at the time considering their poor 1974 profitability results, profitability ratios and the stock price at the time. (see exhibit G). Given their positive prospects for growth the warrants provided significant upside for investors which helped to offset the high risk associated with MCI's financial performance at that time. Equally important to investors was the FCC decision in May of 1974 that required AT&T to supply MCI with interconnection. This ruling supported the possibility for increased market share and profitability for MCI.

In 1978 as their business grew and the need for capital continued to increase MCI raised $25,760,000 through the issuance of 1,120,000 of convertible cumulative preferred stock at a price of $25 per share. The shares carried a conversion price to common stock of $2.1875 per share. The call date for conversion was 15 months later in March of 1980. At the time of the issue MCI stock was trading at a price of $1.875. In 1977 MCI's net income and profitability ratios had improved considerably and their forecast for 1978 earnings was in excess of $5,000,000. Debt ratios, dept to equity and return on equity ratios would all remain within an acceptable range after the issue. (see exhibit H). In addition the court had lifted a restriction on the "Execunet" service provided by MCI which was their fastest growing business and would make significant contributions to revenue and profitability in the years to come.

Nine months later in September of 1979 MCI raised the largest amount of financing in the company's history by issuing 4,500,000 shares of senior convertible cumulative preferred stock with at $15 per share with total proceeds valued at $63,125,000. The conversion date was set for 20 months later in May 1981. This offering was supported by the improved actual and forecasted profitability of the company and the key ratios would remain in an acceptable range following the offering. (see exhibit I)

In July of 1980 MCI issued their first subordinated debenture at a rate of 15% due in the year 2000 raising $50,545,000 in capital. This rate was 346 basis points higher than a firm with an A bond rating. Considering the upward trend in the stock price which reached a high of $2.50 in 1978 and $3.50 in 1979 and with call dates in March of '80 and May of '81 it was highly likely the company would call and convert the preferred shares to common stock increasing the level of equity, erase the debt associated with the issue which subsequently increase their capacity to take on an increase in debt.

Three months later in October of 1980 MCI raised $46,725,000 in capital with an issue of 3,300,000 shares of cumulative convertible preferred stock with a call 13 months later in November of 1981 (see exhibit J). At the time of the issue their key 1979 year ending ratios were within an acceptable range and stayed as such considering both the subordinated