Question 1: How effectively has MCI financed its needs in the past?
In looking through case data from Pg. 2 (68 of course-pack), Exhibit 2 and Exhibit 9A, we see that MCI has gone through two stages:
1. Startup stage from FY1972 through 1977, where the firm generated negative OI
2. Growth stage from FY1978 onwards where the firm started generating positive OI
The financing for the startup phase was performed predominantly through common stock as expected, followed by debt financing. During this stage, MCI had grossly under-estimated its cash requirements to support its build-out strategy which had led to the technical default. This had forced the firm to raise equity financing in ...view middle of the document...
We determine the amount of capital financing needed by taking line (10), after-tax net income and adding back line (16) depreciation, to determine actual capital needed given the forecast of capital expenditure. We made certain assumptions, such as, cash levels will be kept roughly in line with 1983 level of $542 million. In addition, we assumed that tax provisions were actually paid out each year, rather than accruing a liability or deferring taxes to future dates. According to our assumptions and using the forecast we have determined that MCI needs approximately $4.2 billion dollars in the next 4 years, from 1984 through 1987. After 1987 capital expenditure begins to taper off and growth in EBITDA increases to a point where it is enough to finance internally the planned capital expenditures. Over 75% of the capital requirements comes in the later 2 years, in 1986 and 1987.
We are not so certain of these forecasts. The main reason is the top revenue line forecasts which is function of the net income and capital expenditure outlay. If AT&T Communications decides to compete on price by being more aggressive with this new relaxed legislation, the forecasted revenue numbers below may be significantly impacted. MCI can respond to this price competition in a couple of ways, one is to decrease capital expenditure outlays which means that the capital requirements may be a lot less than we need. Second, MCI can respond by keeping capital expenditure and investing in the future to reduce Access charges and use its own network, in which case we have raised less capital than we needed because net income will decrease as a result of the decrease in revenue.
Question 3: What capital structure should MCI adopt?
MCI Communication faces a business strategic environment which is as follows. The independent local telephone operating companies will be providing equal access to all competing long distance providers. This will cause an increase in the access charges paid by MCI (with an 80% increase starting in 1984). This will level the playing field between AT&T and MCI in terms of access charges, thereby removing the cost advantage that MCI currently has. On the other hand, AT&T has considerable pricing power, and at the same time, it has been aggressive in the past. This increases the risk that AT&T will resort to price competition to gain back market share from MCI communication. Therefore, we believe that the top-line risk to the MCI forecasts exists. Therefore, in terms of business strategy, economies of scale and scope are essential and MCI needs to own its facilities for providing basic call services (to eliminate access charges) and leveraging this foundation to provide value-added services.
From the company perspective, it would like to raise medium-term debt to cover capital needs. However, given the price-competition risk presented by AT&T Communications, and given the access fee increases, the best option for the firm is to raise...