Question 1:

MCIs management is committed to a growth program and they are willing to

sacrifice profit margins to achieve it.

Consequently, the companys external

financing requirements will likely increase in years to come. Basing our projections
off of the exhibits and assumptions provided in the case, we estimate MCIs will
invest approximately $3.8B over the next four years (1984-1987) of which $3.3B will
need to come from external sources. As capital expenditures outstrip funds from
operations, undoubtedly the company will need to seek further capital from the
financial markets (Exhibit 1).
However, these external financing needs could vary considerably. For one, as
the antitrust settlement between AT&T and the U.S. Department of Justice
mandates the breakup of AT&T by early 1984, both growth opportunities and cost
uncertainties simultaneously increase for MCI Communications. MCI could certainly
gain by having equal quality of access to all local telephone companies, but to what
extent is difficult to assess. By FY1990, MCI market share is forecasted to hit 20%,
however, this number is contingent upon other competitors in the market and the
market itself as it adapts to the shock of competition. If market share increases
more dramatically or more rapidly than predicted, MCI could have increased
external financing needs in order to support additional capacity requirements. On
the other hand, if future market share is less than forecasted, capital expenditures
could decrease providing a reduction to the external financing requirements. On
another note, MCIs access charges are forecasted to increase by 80% in 1984, but
are expected to taper off in FY1990.

As these numbers are just estimates, any

deviation could drastically impact MCIs profitability and consequently their outside
capital requirements. Additionally, it is forecasted that legislation in Congress will

forbid MCI to pass these direct access charges onto households and businesses,
however, if Congress rules in the telecommunication companys favor, these passthrough charges could reduce their external capital needs.

MCIs capital

requirements could also vary based upon their actual capital expenditures. Capital
expenditures are MCIs biggest cash drain and any deviation from the estimate to
the actual investment factor will directly impact the amount of capital needed to
build out infrastructure. Finally, another varying factor could be impacted by the
FCC mandated city-by-city elections where voting consumers elect their preferred
long distance carrier for their local market.

External capital requirements could

exceed the estimate if MCI is chosen as the preferred carrier in all cities or if the
company is chosen in cities where current infrastructure is not in place.
Question 2:
Through 1976, the companys financial policy consisted of raising capital
predominantly for continuing operations. Two and a half years after MCI was
organized, the company incurred enormous fixed costs through the growth of their
communications network to 30 metropolitan areas with 5,100 route-miles of
transmission circuits.

As a start-up telecommunications company with limited

capital, these costs were majorly funded through the issuance of common stock, a
credit line from a syndicate headed by the First National Bank of Chicago and
subordinated notes from private investors. Dependent upon AT&T facilities to carry
calls from its subscribers to MCI transmission centers, MCI was unable to generate
significant subscriber revenue to justify the accumulated operating expenses that
accompanied the newly built and growing communications network. By 1975, MCI
was in technical default and their working capital had decreased $7.7M from FY
1974 to FY1975 to ($7.4M), making the company unable to meet its short-term

liabilities with its current assets. Between the 1976 court order preventing the
extension of Execunet service to new customers and the restrictive covenants on
the bank loans from the First National Bank of Chicago syndicate, MCI was between
a rock and hard place; the need for investment funds was significantly reduced
through the court order and the restrictive covenants severely limited MCIs ability
to raise new funds for expansion.

With the court order restricting growth

opportunities through Execunet for nearly two years and not left with many other
financing options, MCI utilized lease financing on new fixed investments to expand
capacity into MCIs existing markets.
Once the courts Execunet order was withdrawn in May 1978, in an effort to
retire all short-to-intermediate term bank debt and convert all outstanding warrants,
MCI sold convertible preferred stock three times within a two year period for net
proceeds of approximately $136M.

Through the proceeds, the company also

decreased leasing activity which also provided the opportunity to raise an additional
$152.6M through long-term subordinated debentures and approximately $344M in
convertible bonds with forced call provisions.

Financing capital through convertible

preferred stock had many advantages for the company. First, equity financing freed
itself from debt holders restrictive covenants. Second, issuing convertible preferred
stock didnt immediately dilute the companys common stock. Third, in terms of
marketability, the dividends on the preferred stock were 85% tax deductible to
corporate purchasers since MCI positive earnings from 1978 onward were offset by
the loss carryforwards from previous years.

Finally, the call provision on the

preferred issues prevented a cash drain from payment on preferred dividends.

Through the companys rising stock price, this feature ultimately provided MCI the
ability to convert all preferred issues to common stock by 1981. Because the stock

price

continued

to

rise,

MCI

could

call

its

debt

and

perform

forced

converstionconversion into equity. Since the companys equity was also increasing
with each conversion, room was made for additional debt. Because of this cycle,
the company was able to maintain a reasonable debt-to-equity ratio. . Similarly, the
convertible debentures with forced conversion provisions gave MCI the opportunity
to convert debt to common stock almost immediately.

This growth in common

equity resulted in a further debt burden for MCI, all the while providing the company
with the funds to make the required investments for growth in order to maximize
shareholder wealth .

From FY1981 to FY1983, earnings per share increased by

1778% to $1.69.

One thing we need to say here is that the convertible debt allowed MCI to maintain
a reasonable D/E.

Because stock price kept increasing, MCI could call debt and

force into equity which made room for additional debt because equity was larger.
Question 4:
Given the alternatives, we recommend that Mr. English choose the $1 billion unit
package to raise capital as of April 1983. The use of a package consisting of a bond
and a warrant has several advantages over the other choices. First, this offering
can be categorized as equity instead of debt on MCIs balance sheet. MCI can avoid
a debt overhang problem since it already projected the need to raise a lot of capital
for expansion over the next few years. Second, MCI can offer a lower coupon rate
due to the embedded value in the warrant. A lower coupon rate lowers the risk of

financial distress since its cash flow can easily cover the interest payment. Third, a
unit package lets MCI capture the full value of their equity at a later date, while
being able to raise capital now. MCI stock has high potential to be undervalued due
to uncertainty that the telecommunication industry is experiencing. Therefore, if
MCI chooses to issue equity, they would not be able to raise as much capital.
Over the next 3 years, MCI has a need to raise a projected $3.3 billion to finance
their growth. In keeping with its current debt to capital ratio of 55% (case exhibit
8), MCI only need to issue $1 billion worth of equity and the rest as debentures.
Equity should be raised first in order to make MCIs ratios look good, so that it can
offer a lower coupon rate when it is time to issue bonds. Since cash is projected to
run out in 1987, it should raise capital over the next three years (1983-1986).

Exhibit 1 Forecasted Inflows, Outflows and Cash Balance

Using the assumptions provided in Exhibit 9 of the case, we forecast that the overall
cash outlay in years 1984-1987 will be $3.8 B. As of 1983, MCI only has $542M in
cash on hand. In order to finance the required investments, MCI will need to raise
an additional $3.3B over the next four years.
FY 1984

FY 1985

FY 1986

FY 1987

4 Year Total

Inflows

$448.0

$595.0

$889.0

$1,309.0

$3,241.0

Outflows

$890

$1,467

$1,931

$2,760

$7,048

Net

($442.0)

($872.0)

($1,042.0)

($1,451.0)

($3,807)

Cash as of 1983

$542

Cash Shortage

($3,265)