We begin this chapter with a review of the previous two chapters. This has two purposes: one to reinforce the material for the reader; the other, to allow this chapter to be read on its own. In particular, we are going to review and expand the discussion of asymmetric information and signaling from the earlier chapters. Then we will use MCI to illustrate how a firm’s operating strategy impacts its corporate financial policies.

A Brief Summary

We noted (in Chapters 8 and 9) that the following actions provide signals to the market. When a firm issues equity, its stock price drops on average. When a firm does a tender offer for its own shares, the firm’s stock price rises on average. When a firm initiates a dividend for the first time or raises its current dividend, the stock price goes up. When a firm cuts or eliminates its dividend, the stock price goes down. All of these price reactions are statistically significant.

In the last chapter, we stated that the market’s reaction to these events is due to asymmetric information. The insight behind why asymmetric information matters is that investors believe that managers have more information than they do, so investors therefore watch and react to what management says and does. A secondary insight is that investors don’t know whether what management is saying is credible or not. However, investors do know that if management increases the payout of equity cash flows, then there is probably an excess of cash flows to the firm. (Payouts of equity cash flows are executed with stock repurchases and increased dividend repayments.) Furthermore, if the management raises new equity or decreases equity cash flows, then there is probably a shortage of cash flows. (Raising new equity or decreasing equity cash flows are executed by stock issues and dividend cuts.) Thus, equity cash flows provide information, or signals, to investors. As a consequence, stock price will rise when the firm pays out equity cash flows, since it signals excess cash flows, while the stock price will fall when new equity is issued or when equity cash flows to investors are reduced, since these signal reduced cash flows.

Since investors react to “signals” from the firm, let’s now ask: What makes a good signal? A good signal should be credible and simple to understand and calibrate. In addition, a signal should also be visible—something that all investors will notice. Finally, there should be a penalty for false signaling. Now imagine a CEO speaking before the Society of Security Analysts and saying that the firm is “doing very well.” What does “very well” mean? Suppose the CEO instead says the firm is “doing well.” These statements are not much of a signal. It is very hard to determine the difference between “very well” and “well.”

Cash flow in and out of the firm is almost the perfect signal. First, cash is credible: management is actually paying out or taking in cash. Second, cash is simple to understand and calibrate—investors do not have to interpret the difference between doing “well” versus “very well.” If a firm increases its dividend from $1.00 per share last year to $1.50 this year, it is clear the firm is paying 50% more. Third, cash is visible. Investors might not read the annual report or hear the message from the CEO, but they will notice the firm’s dividend payments and will absolutely “cash the check” (dividends no longer come as physical checks, but we like the imagery). Finally, there is also a real penalty for false signaling. If management misleads investors and is in fact not doing “well” but has increased cash dividends anyway, management must replace that cash somewhere else later.

An analogy: Imagine you attend your class reunion. One former classmate is boasting about how well he has done since leaving school and even offers to show you his audited financial statements. At the same time, another classmate is handing out $1,000 bills in the corner. Which former classmate do you believe is doing better? The one boasting or the one handing out cash? The one handing out cash is more credible. This is an example of signaling.

Now let us put together some of what we have learned so far from the Marriott and AT&T chapters. We know firms are reluctant to issue equity. This fact makes other financial concepts important, for example, sustainable growth. There is power to the concept of sustainable growth if firms are reluctant to issue equity. If a firm cares about its capital structure and how much debt it has, yet is reluctant to issue new equity, then the ability to generate internal equity (which sustainable growth measures) is important. In addition, having cash on hand or lines of credit the firm can draw upon (sometimes called “financial slack”) is important because the firm doesn’t necessarily have to go to the capital markets at what might be an inopportune time. Signaling makes a firm’s internal capital markets and its generation of internal cash flow important.

Signaling and its consequences also give rise to something called the pecking order theory (introduced at the end of Chapter 9). The pecking order theory is predicated on the idea that a firm first looks for funds internally before going to the outside capital market. Furthermore, if a firm raises capital in the outside capital markets, the firm will look to issue debt first and will look to issue equity last. Empirically, we see this result in two ways: First, in the percentage of funds obtained from internal growth versus debt versus equity. Second, in how the market reacts to each kind of financing—remember how the market reacts to equity cash flows in and out of the firm. In addition, there is no market reaction to new debt issues.

Let us list some financial objectives for firms (this is not a complete list, but it is illustrative of the trade-offs that occur in corporate finance):

1. Do all positive-NPV investments. A firm should undertake any project that has a positive NPV since it increases firm value.
2. Maintain an optimal debt/equity level. This allows the firm to minimize the cost of capital and maximize the stock price without undertaking excessive risk.
3. Don’t cut dividends. We will talk more about this in the next chapter, but firms rarely cut dividends for any reason.
4. Finally, don’t issue equity.

So let’s say you are the CFO of a firm and this is your checklist. The problem is achieving all four simultaneously. There are trade-offs. For example, if the firm has a lot of projects with positive NPVs, but the funding needs for the new projects are greater than the firm’s cash flows from sustainable growth, what should the firm do? If the firm wants to achieve the first objective and accept all positive-NPV projects, then it must do one of the following: issue new debt, issue new equity, or cut dividends. In other words, it must violate one of the other objectives. It is nice to have the four objectives, but they can’t necessarily all be achieved at the same time. This is where the trade-offs come in and where corporate finance becomes fun. If the CFO can achieve all four objectives every year, that is great. The old AT&T did this consistently year after year. Not every firm can do this, however, including the new AT&T.

This ends our review of the prior chapter where we analyzed AT&T, both pre- and postdivestiture (what we called the “old” and “new” AT&T). We looked at the old AT&T’s policies and its funding needs, then we looked at the new AT&T’s policies and its funding needs.

Now we turn to MCI, a competitor of AT&T, and we will follow a parallel structure to Chapter 9. First, we will look at the old MCI and how MCI competed with AT&T before AT&T’s divestiture in January 1984. We will also look at the old MCI’s financial policies and funding needs. Then we will examine the new MCI (after AT&T’s divestiture) and its policies and funding needs. (Your authors think it is useful to use MCI with AT&T to discuss these issues. It allows us to talk about the same financial concepts with two very different firms in the same industry at the same point of time.)

A Brief History of MCI

MCI (originally Microwave Communications, Inc.) was founded in 1963 by John Goeken.¹ William McGowan, who later became CEO, joined the firm in 1968. The firm’s initial business plan was to use radio waves and relay stations to transmit point-to-point private phone calls in Illinois and Missouri for trucking companies and other small businesses that wanted to pay less than AT&T’s high long-distance charges. In 1968, MCI decided to expand its microwave relay communication system nationwide. MCI obtained FCC approval for its plan in 1969. In 1980, MCI expanded its service from business customers to residential customers as well. By 1990, MCI was the second-largest telecommunications firm in the United States.

While MCI’s business plan relied on relaying phone calls from relay station to relay station, MCI still required AT&T’s local phone lines for transmitting phone calls to and from the MCI stations. For example, if a MCI customer wanted to make a phone call from Chicago to St. Louis, she would use AT&T (technically Illinois Bell, an AT&T subsidiary) from their office to the Chicago MCI station, and then MCI would transmit the call from Chicago to St. Louis via microwave. The call from MCI’s St. Louis station to the local St. Louis phone number would again be carried on AT&T’s local phone lines. With this plan, the MCI customer only paid for local phone service and avoided AT&T’s long-distance charges.

AT&T fought MCI’s competition by refusing to allow MCI to access AT&T’s local phone lines. This meant that while MCI could transmit communications between its own relay stations, those stations could not receive or send calls that connected MCI’s customers. MCI fought back with numerous lawsuits, including a charge filed in 1974 that accused AT&T of violating the U.S. government’s antitrust laws (a charge the U.S. Justice Department also made in a separate case in November 1974).²

Eventually, the U.S. Justice Department’s lawsuit resulted in the 1982 decision that AT&T had to divest its local phone service (the Baby Bells). The divestiture took place in January 1984.

Convertible Preferred Stock and Convertible Bonds

As shown in Table 10.4, MCI issued many convertibles, both convertible bonds and convertible preferred stock. What is a convertible? It is a bond or preferred stock that gives its holders an option to convert into stock. For ease, let’s just discuss bonds (convertible preferred shares work similarly). A convertible bond is basically a straight bond with an equity option. How does it work? The bond has a conversion ratio and a conversion price. Let us say a firm issues a $1,000 bond that converts into 20 shares. What is the conversion price? $50, which we calculate by taking the face price of the bond ($1,000) and dividing by the number of shares the bond converts into. Alternatively, if you have the bond’s issue price and conversion price, you can find the number of shares it will convert into: for example, a $1,000 bond divided by a conversion price of $50 is 20 shares. Typically a firm will issue a bond so the conversion price is 15–20% above the current market price of the shares. In other words, the conversion option is “out of the money.”

Will the coupon on a convertible bond be above or below that on straight debt? Below. Why? The firm is giving the buyer an equity option, which has value, and in return pays a lower coupon rate. On straight debt, the buyer only gets the coupon value and has no upside in the stock price. With a convertible, if the stock price goes up enough, the bondholder will receive a portion of the gain. This is why the buyer of a convertible will accept a lower coupon. In addition, the more valuable the option, the lower the coupon.

What price will a convertible bond trade at? A convertible bond is valued as the maximum of either the underlying straight bond or the value of the converted equity. It will trade at close to its bond value as long as its conversion value remains out of the money. That is, it will trade at the present value of the coupons discounted by the market interest rate (plus a small premium for the out-of-the-money equity option). Once the conversion option is in the money, however, then the bond will trade close to the value of the converted shares. That is, it will trade at close to the stock price times the conversion ratio (plus a small premium for the put value, as explained below).

As an example, imagine a $1,000 bond with a conversion ratio of 20 and a conversion price of $50. Now assume the price of the stock is $60. The conversion value of this bond, if it converts into 20 shares, is $1,200. Therefore, if you own this bond, you are never going to sell the bond for less than $1,200 because you could get $1,200 for the shares you can convert it into. Actually, the bond may sell for a bit more than $1,200 because it is actually more valuable than 20 shares of stock. Why? Because the bond has protection on the downside. If you owned 20 shares of stock instead of the convertible bond and the stock price were to drop from $60 to $40, the value of your shares would fall from $1,200 to $800. But if you owned the convertible bond, you would still receive the interest and maturity value of the bond, which should be worth more than $800. This is why a convertible bond will trade for at least the maximum price of the equivalent straight bond or the value of the converted equity.

Let’s ask a new question: If the stock price goes up to $60, should you convert the bond? What is more valuable: 20 shares of the stock at $60, or a bond that converts into 20 shares? The bond. As explained above, the convertible bond is worth more than the stock because of the put option. This means a smart investor is not going to convert voluntarily because he would be giving away the put option. If an investor wants to get out of the investment, he would not convert the bond to sell the stock: he would simply sell the bond.⁸

Financial economists have a name for people who convert early. We call them doctors. The stereotype is that they are investors who have money to invest but no clue about what they are doing financially. Anyone who converts early is extinguishing a valuable option. So if investors do not convert voluntarily, how does a firm, like MCI, get rid of its convertibles? Convertibles are callable, and the company calls them to force conversion. When a convertible is called, an investor must decide to either convert the bond into stock or receive $1,000 par value in cash from the firm. This means, if the stock price is at $60 per share with a conversion ratio into 20 shares, then the investor can convert his 20 shares into $1,200 of stock or receive $1,000 in cash. Normally investors have a 30- or 60-day period to make the decision, and at the end of the period, they have to inform the firm of their choice. Now what should the investor do? Convert: $1,200 worth of stock is more valuable than $1,000 in cash.

As an aside, perhaps surprisingly, typically only about 98% of investors convert when a firm calls a convertible. There are 1% to 2% of investors who will take the $1,000 in cash rather than take the $1,200 in stock.⁹ (We want to get a mailing list of those people because we have all sorts of things to sell them.)

Now, why did the old MCI issue convertibles? Why didn’t the firm simply issue straight equity? The reason was that, as we have seen, if MCI issued straight equity, its stock price would have fallen. What about issuing convertibles? Do firms’ stock prices fall when firms issue convertibles? Yes, but not by as much, as we will explain below.¹⁰

Should the old AT&T have issued convertibles? We argue no. Why not? Consider the coupon rates AT&T would have gotten on a convertible compared to its coupon on straight debt. We mentioned above that the coupon on convertible debt is typically below the coupon on straight debt because of the convertible’s option value. How much below depends on the value of the option. The greater the potential upside of the stock price, the greater the value of the option and thus the larger the discount on the coupon.

As an example, consider a stock that is worth $30 today and that investors expect to be worth $30 tomorrow and $30 forever (paying a dividend but remaining at a $30 price). Assume this firm can issue 10-year straight debt at a coupon rate of 10%. What coupon rate would you expect it would obtain on a 10-year convertible debt? The same 10% rate. Why? Because there is no option value on the stock since the stock price is expected to remain at $30 (note that this is an exaggerated example used to make a point). Remember, the reason MCI was able to obtain a lower coupon rate by issuing a convertible was because of the high option value of MCI’s stock.

So, what kind of firms issue convertibles? Start-ups, and/or firms with high tech or high R&D, as well as firms with volatile cash flows. In other words, firms with large option values (i.e., firms whose stock prices may rise significantly) and firms for which high fixed-interest expenses may be problematic. AT&T, for example, should not issue convertibles. Why? Because the market did not think there was very much upside to its stock price. AT&T’s stock price was $68.50 a share at the end of 1983, a 17-year high. Furthermore, AT&T had a low interest rate on its straight debt, and it had adequate, stable cash flows to service its debt. Thus, AT&T would not get much of a reduction in interest rates for issuing convertible debt, yet would give away any potential upside in stock price.

Convertible debt was attractive to MCI, because its high option value meant it would obtain a much lower interest rate. The cash flow savings from the lower interest rate were important to MCI since its forecasted cash flows were volatile. In 1982 MCI paid a 14.5% coupon on straight debt, yet only 10% on convertible debt.¹¹ The reader should remain aware, however, that when MCI issued convertible debt, it was potentially giving away the firm’s stock prices’ upside in exchange for a lower interest rate. This meant, if stock prices rose enough, MCI would ultimately be issuing equity at a low price via convertible debt.

Our next question: Why does a firm’s stock price fall less when it issues convertible debt than when it issues equity? As discussed earlier, the stock market seems to interpret an equity issue as meaning the firm has uncertain opportunities or insufficient equity cash flows. If the firm issues convertibles, the market is still troubled but less so. Empirical research shows there is an approximately 3% decline in stock price for an equity issue of about 10% of a firm’s capital and a 1% decline for a convertible debt issue of the same amount.¹²

An intuitive explanation of why the market interprets convertible issues less negatively than equity issues is as follows: If a firm is certain that future cash flows will be sufficient to pay back a debt issue (i.e., there is no risk of default), and the firm expects its stock price will rise, it should issue debt and not give away the equity upside to new investors. However, if the firm is uncertain whether future cash flows will be sufficient to pay back a debt issue, then the firm will probably issue equity. In doing so, the firm avoids the risk of default, but it does send a negative signal.

Convertible issues send a negative signal but a smaller one than equity issues. A reason the signal is smaller is that if stock prices don’t increase enough to force conversion, convertibles remain debt, which has to be serviced and repaid. Another way to understand this is that if management misleads the market when issuing equity, there are no cash flow consequences to the firm. However, if management issues convertible debt, which doesn’t convert, the firm will still have the debt and have to pay it off. Unconverted convertibles essentially become straight debt. A firm has to make its interest payments or put itself at risk. Thus, convertible debt is a middle ground between straight debt and equity.

Finally, a last way to look at this signal is that when a firm issues equity, the market interprets this as management thinking that the stock price is at a relative high or management anticipating that things are not going to be as good in the future. Issuing convertible debt with the hope that it will convert in the future indicates that management believes the stock price will rise.

To simplify: Those firms with positive NPV projects and lots of positive cash flows will finance with straight debt. Better firms, with positive opportunities but volatile or limited cash flows, will issue convertible debt. Finally, firms with uncertain opportunities and cash flows will issue equity (if they issue debt, even if it is convertible, and things don’t go well they are saddled with a high probability of financial distress).

Interest Rates and Debt Ratios

What were MCI’s interest rates on the straight debt issues? In Table 10.4 the stated coupon rate on straight debt is not the actual interest rate paid. This is because these debt issues were original issue discount (OID) bonds.¹³ Let’s take the April 1981 debt issue as an example. Since this was an OID bond, MCI did not sell the bond at par value but in fact sold it at substantially below par: at 84.71% of par. Thus, MCI received only $847.10 for each $1,000 par value bond. However, this debt issue had a stated coupon rate of 14.125% on the $1,000 par value, or $141.25 per bond. This means the real interest rate MCI was paying was much higher than the stated 14.125%. MCI’s actual interest rate on this debt was 16.8%.¹⁴

What is MCI’s debt ratio? After all this financing activity, MCI’s debt level at the end of 1983 was $943.9 million with total capital of $1,709.5 million ($943.9 million of debt plus $765.6 million of equity) for an apparent debt ratio of 55.2%. However, MCI also had $500 million in cash from its latest round of financing (the total cash balance was $542.0 million, so MCI had $42.0 million of cash on hand prior to the financing). This presumably means that the $500 million of cash from financing is excess cash. As you may recall, excess cash is the same as negative debt. (The previous point is in bold because it is an essential point in corporate finance and one often missed by both students and practitioners.)

This means MCI effectively had $443.9 million of debt ($943.9 million of debt less the $500 million of excess cash) and total capital of $1,209.5 million ($443.9 million of effective debt plus $765.6 million of equity) for a debt ratio of 36.7%. Essentially, this was the debt ratio the instant before MCI issued the new $500 million of debt. Had MCI never issued the additional debt, the firm would have only had $443.9 million of debt with $765.6 million of equity producing a debt ratio of 36.7%.

The fact that MCI issued $500 million of debt and kept it in cash did not really change the firms’ debt ratio because MCI could have used the cash to pay down part of its debt. If a firm uses excess cash to acquire other assets, then all its debt is included in the firm’s debt ratio. The bottom line is that, at the end of 1983 MCI’s actual debt ratio (after taking in account excess cash) was 36.7%.

Leases

MCI also did lease financing. What is lease financing? With a lease, a firm requiring a particular asset for its business essentially rents the asset long term from another firm. This happens in one of two ways: First, an outside firm may already own the asset and lease it to the firm that needs to use it. Second, the firm that needs to use the asset can buy the asset themselves and then sell it to an outside firm while signing a lease contract to use it. Why would a firm buy an asset, sell it to another firm, and then sign a lease to use the asset it just sold? Why wouldn’t the firm just buy the asset themselves to use it? And why would the lessor firm sign up for this? The advantage to the firm leasing the asset (e.g., MCI) is that they get to use the asset without having to finance the cost—it is similar to renting rather than owning a house. The advantage to the firm owning the asset is that they collect the lease payments and also are able to use the tax shield from depreciating the asset.

Doesn’t MCI care about the tax shield? Only recently. MCI’s first year of profitable operations was in 1977 (after suffering over $100 million in losses in its first 14 years of operations). This means MCI did not have taxable profits and would thus not have benefitted from a depreciation tax shield. Even until 1980, MCI was using its past tax loss carryforwards.¹⁵ In addition to the tax consequences, MCI did not have enough cash flows or debt capacity to fund all its required capital expenditures. By using leasing, MCI only had to fund the annual lease costs.

Financing Needs of the New MCI

Let us now turn to the financing requirements for the “new” (post AT&T’s divestiture) MCI in January 1984. To do this, pro forma financial statements must be prepared. (As with AT&T, since this chapter is about the consistency between operating and financial policies, rather than about pro formas, we relegate the details of how the pro formas are done, and the Income Statements and Balance Sheets, to Appendix 10, and Tables 10A.1 10A.2, and 10A.3.

The two key elements in estimating MCI’s pro formas are MCI’s sales growth and its sales-to-asset ratio. That is, how fast MCI is going to grow and how much in capital expenditures (CAPEX) they are going to need to build a network to support the growth. As can be seen in Table 10.1, MCI’s sales growth averaged a very high 74% over the 1979–1983 period (28.6%, 51.6%, 62.3%, 116.2%, and 112.0% respectively) while its total assets grew at an average rate of 70.7% (29.9%, 47.9%, 50.7%, 84.3%, and 140.6% from 1979–1983 respectively) as MCI built its network.

This high rate of sales growth is clearly not sustainable. At the beginning of 1984, MCI’s sales growth is coming from two sources: first, the growth in its overall long-distance revenue (which is growing at 15% a year during this period).¹⁶ This provided a minimum growth rate for MCI if its market share stayed the same. The second source of growth for MCI is from capturing some of AT&T’s market share. (Importantly, MCI is not the only new phone company on the block in January 1984: other firms, including GTE and IBM, are also seeking to capture market share.)

MCI’s high growth in assets should also decrease as MCI’s network gets built up. MCI, initially had falling sales/assets ratios as it built up its infrastructure. Then, once the infrastructure is built and sales expand, the sales/assets should increase. There are firms whose sales/assets remain constant over time (e.g., fast food restaurant chains typically only have their sales expand with new outlets).

To summarize, the two key elements for MCI’s pro formas covering the period after 1984 are the estimated sales growth (which will probably slow down as MCI penetrates the market) and the sales/asset ratio (which should increase with slower future CAPEX and asset growth). Appendix 10A provides the details of your authors’ assumptions for the pro forma Income Statements and Balance Sheets. Table 10.5 presents the pro forma cash flow statements derived from these assumptions.

As seen in Table 10.5, MCI is forecast to fund its pro forma financing needs with earnings, depreciation, and outside financing. Earnings are forecast to be $139 million in 1984 and to steadily rise to $535 million in 1988 for a total of $1.56 billion over the five-year period. The depreciation estimates increase from $175 million in 1984 to $481 million in 1988 for a five-year total of $1.81 billion. Thus, the five-year cash flow provided by operations is estimated at $3.37 billion.

The differences between MCI’s pro forma cash flow from operations and the pro forma CAPEX are MCI’s financing requirements. As shown in Table 10.5, MCI’s net financing needs are forecast to be $710 million,¹⁷ $879 million, and $847 million in 1984, 1985 and 1986 respectively. In 1987, the financing needs are forecast to be essentially zero (showing a $4 million excess). By 1988, MCI’s financing needs are a negative $480 million. Why? Because as MCI’s capital expenditures needs go down (as MCI’s initial network is complete) and the firm’s profits go up, it becomes able to internally fund its capital requirements.¹⁸ Thus MCI’s cumulative financing needs are approximately $2.44 billion from 1984 through 1986 before its product market strategy matured and net financing was reduced to below zero.

Why is there this pattern of rising and then falling net financing requirements? MCI’s income rises throughout the five years. At the same time, its capital expenditures rise and then fall.

Note: As seen in Appendix 10A, increases in working capital are assumed to net out to zero throughout this time period. The argument is that MCI has virtually no inventory needs, and its low receivables will be balanced against its payables.

Now let’s remember something important here: The preceding is MCI’s expected scenario. Just as we did in the AT&T chapter, we also have to ask: What is the worst-case scenario for MCI? For AT&T, we assumed profits would fall near zero but that the firm would still survive. For MCI, we really have two potentially worst-case scenarios. In the first, profits go to zero, which means MCI will require an extra $1.56 billion in financing over the next five years (i.e., earnings will be reduced by that much). This means that MCI will require approximately $4.00 billion of financing (for 1984–1987), slightly more than 50% above the estimated $2.44 billion in the base-case forecast in Table 10.5. Thus if MCI has no profits, it will need more cash to stay alive.

However, there is another worst-case financing scenario for MCI. MCI will need more cash if MCI grows faster than expected! At the end of March 1983, MCI had approximately 3% of AT&T’s long-distance revenue. In Appendix 10A’s pro formas, we assume that the market grows at 8% each year, that MCI’s market share grows to 10.8% by the end of 1988, and that the sales/PP&E ratio increases from 80.0% in 1984 to 117.6% in 1988. Now suppose the market grows faster than 8% and/or MCI captures a larger share of the market and/or the sale/PP&E ratio does not increase as rapidly. What are MCI’s capital expenditures needs in this situation? Much higher. This revisits what we learned in Chapter 3. The faster a firm grows, the more working capital and CAPEX it requires, and thus the more financing the firm needs.

Let’s briefly review this concept. Using the pro formas in Table 10.5, we project out an expected case that requires MCI to raise $2.44 billion of financing over the next three years. In the last two years, MCI is expected to have excess cash and can pay down debt. MCI’s financing needs could be higher than forecast for two plausible reasons. One, if MCI’s profits are not as high as forecast. Two, if MCI is more successful than forecast (i.e., takes more market share), it will have to build a bigger network and finance more lines, more substations, and so on.

MCI’s Financing Choice

Let’s return to the question: What should MCI issue? As we saw, among MCI’s choices, straight debt is dominated by debt with warrants. Even if the bond-with-warrants issue does not convert, it allows MCI to issue a larger amount at a lower interest rate. Convertible debt is also dominated by usable debt with the warrants: MCI can issue a larger amount with better terms than those of convertible debt.

What about choosing to do both options 1 and 2, that is issue both debt and equity? The unit issue of debt with warrants is slightly superior to the combined debt and equity issues. Why? In state 1 the two options have roughly the same amount of debt and roughly the same amount of financing raised. The debt with warrants has a much lower interest rate on the debt but it has twice as much debt, so the net effect is that there is a higher total interest charge on the debt with warrants. However, in state 2, the unit deal of debt with warrant financing is clearly superior once the debt is converted.

This means the real choice for MCI is between issuing straight equity, or usable debt with warrants. So now we clearly come to the part of corporate finance where there is no precise, correct answer. Should MCI issue equity or the debt with warrants?

If MCI issues equity, the firm has $425 million of funding, and it has the lowest debt ratio in state 1. If MCI issues debt with warrants, it is riskier, but the firm will have $1 billion of funding regardless and the lowest debt ratio in state 2. It is probably worth noting here that if MCI did not take risks, the firm would never exist. This was, after all, a start-up company that went after AT&T, one of the world’s largest monopolies.

What did MCI do? Note, your authors would probably not be discussing a usable debt-with-warrants issue if one did not actually exist. MCI issued the debt with warrants in July 1983.²⁵ What happened next? Profits were not as high as forecast in our pro formas. AT&T cut rates once it was allowed to do so, and the Baby Bells were allowed by the FCC to increase the interconnect charges. As a result, MCI also had to cut rates while its costs increased, both of which lowered the firm’s margins. MCI’s revenues went from $1 billion to $4 billion over the next five years. However, MCI’s net income went from $171 million to $88 million over the same five years.

MCI Postscript

MCI’s stock price peaked at $47 in July 1983, and, for most of the projected period discussed in this chapter, from 1983 to 1988, the stock price fluctuated around $10 a share. As a consequence, all of the convertible debt (which was convertible at $53 per share) remained on the Balance Sheet, as did the warrants. (That is, none of it converted.) MCI’s debt ratios rose from 55.2% (not adjusted for excess cash) in 1983 to 68% at the end of 1987. What happened next? MCI not only suffered in the short term, but to avoid cutting capital expenditures too much, the firm had to cut back on its marketing costs.

Recall that MCI was competing in “elections” for long-distance-carrier market share during this time, which meant marketing expenditures were essential. These elections had been ordered by the courts and would occur only once. If MCI did not win these elections, when would the next opportunity be? Never. After the elections, MCI would have to gain new customers one by one. When we examined Massey Ferguson we talked about its losing markets permanently to Korean and Japanese firms. With MCI, any customers lost in the election were losses in market share for a long time period, if not forever.

So what did MCI do? The firm began to “shop” itself (i.e., it started looking for a merger partner to acquire the firm). The problem was that no one wanted to buy MCI. Eventually IBM bought 18% of MCI’s equity. However, IBM did not pay cash using its telecommunication operations (which had not been successful) as payment instead.

Now suppose MCI had issued equity and the world changed as it did. What could MCI have done then? Perhaps issue more equity, maybe issue more debt. MCI’s debt ratios would definitely have been lower. Would this have been enough to avoid cutting marketing expenses? Perhaps, but not with certainty.

In addition, McGowan, who was CEO of MCI and ran it throughout this period, had a heart attack and a subsequent heart transplant in 1991. Interestingly, MCI did not announce his heart attack or transplant until two weeks after the fact. The SEC investigated and ruled that even though McGowan was the CEO of the firm, his absence and medical condition due to a heart transplant was not material information that investors needed to know.²⁶

McGowan gave up his position as CEO after his heart transplant and died in June 1992 at the age of 64. At the time of his death, MCI had annual sales of $10.5 billion, net earnings of $609 million, and 31,000 employees. The company had also accomplished its goal of providing nationwide phone service. In 1993, British Telecom paid $4.3 billion for a 20% stake in MCI.

A last aside: On September 14, 1998, MCI merged with WorldCom in a $40 billion deal. From 1998 to 2000, the firm was called MCI WorldCom. From 2000 to 2003, the MCI name was dropped, and the firm became WorldCom. WorldCom filed for bankruptcy on July 21, 2002 (the largest bankruptcy filing in the United States at the time) after having overstated total assets by an estimated $11 billion (the largest fraud in the United States up until that time).²⁷ In 2003, the firm changed its name back to MCI (as noted in Chapter 5, firms in bankruptcy tend to change their names). The firm was purchased by Verizon Communications in January 2006 and is now part of Verizon’s operations.

Summary

It is important to remember that MCI was the smallest firm in its industry. It was also the riskiest firm in its industry. In addition, this was a period of tremendous business risk due to deregulation and the “phone elections.” Given this combination, a firm does not necessarily want to have the highest debt ratio in the industry. Now if stock prices had gone up, the firm would have been fine. Unfortunately, they did not go up, and MCI ended up looking a bit like Massey, with AT&T playing the role of John Deere. In addition, MCI was a lot smaller in relationship to AT&T than Massey was to Deere.

Let us summarize:

1. Financial policies should support a firm’s investment strategy.
2. Financial policies not only concern a firm’s debt/equity ratio, they also concern the firm’s choice of debt (long versus short, fixed versus floating, etc.), the type of equity (i.e., preferred, convertibles, etc.), the dividend policy, and more.
3. Financial policies must be consistent with each other. Remember the overview of the corporate finance diagram, which we have discussed twice. It starts with a firm’s product market strategy and financial strategy. The financial policies in the chart (under financial strategy in Chapter 1) must be consistent with each other. This is another way of saying these policies are not separate. For example, a firm does not just randomly set a dividend policy. The amount a firm pays in dividends is integrated into the amount the firm will need to raise in external financing, which is then integrated into the firm’s capital structure.
4. Financial policies convey information. Because of asymmetric information, investors interpret financial policy decisions as signals.
5. Asymmetric information and signaling create a reluctance by firms to cut dividends and a reluctance to issue equity. This creates a pecking order that makes sustainable growth and internally created funds preferable to outside financing.
6. There are a number of hybrid instruments that are designed to mitigate this signaling effect (e.g., like convertibles, PERCS).²⁸ How a firm obtains its financing matters.
7. A firm must not only decide what its static financial policies are, it must also worry about the dynamic of how the firm obtains them. The dynamics of overshooting or undershooting a static policy must be understood. In addition, a firm’s financial policies must change with changes in its product market strategies (as we saw in Chapter 7 with the Marriott).

Remember: All firms need to set policies, these policies have to be consistent, and policies convey information.

Appendix 10A: Development of MCI’s Pro Formas 1984–1988

MCI’s pro formas, Tables 10A.1, 10A.2, and 10A.3 (as all pro formas), can be generated many different ways. In the real world, numerous sensitivity analyses would be done, including Monte Carlo simulations. However, as this is not part of our lesson for this chapter, and for simplicity, your authors have generated a set of pro formas using the following assumptions. (We are assuming that a reader who has been with us since the beginning of the book will understand how pro formas are generated and will be able to change the assumptions and generate his own pro formas.) In what follows, we list the line items in the pro formas one by one and briefly state our assumptions.

Sales: As noted in the text, your authors assume MCI’s sales will both grow as the market for long-distance telecommunication grows and as MCI increases its market share (we also assume the growth in MCI’s market share slows over time). The pro forma assumes the overall market grows at 8% for the entire period and that MCI increases its share by 50% the first year, then 40%, 30%, 20%, and 10% by 1988. This produces a net increase in sales of 62%, 51%, 40%, 30%, and 19% for the years 1984–1988, respectively.

Interconnect, installation, and operations costs: Set at 40% of sales throughout the forecast period, as that was the average over the 1978–1983 period.

Marketing, general, and administration expenses: Set at 30% of sales, which is higher than the 20% average over the 1978–1983 period. We assume this increase will happen because MCI will likely have to increase its advertising and marketing effort and expenses in order to capture market share.

Depreciation: The average PP&E (the average of the opening and closing amounts) is reduced evenly over 10 years (i.e., using straight-line depreciation).

Interest expense: Calculated as the opening amount of total debt (short-term debt plus long-term debt) times 14% (which is about 3% above the U.S. 10-year rate at the time).

Income tax: Set at 35% of profit before tax.

Cash: Set at 5% of sales (the median value from 1978–1983).²⁹

Accounts receivable: Set at 12% of sales (the average value from 1978–1983).

Other assets: Both current and long-term other assets are, for simplicity, assumed to remain constant over this time period.

PP&E: This is set at 125% of sales in 1984 and 1985, 120% of sales in 1986, 100% of sales in 1987, and 85% of sales in 1988 (this gets us almost no change in 1988). This is done because, as noted in the text, the firm’s investments in its network (CAPEX) should fall over time, causing the PP&E/sales ratio to increase.

Current portion of long-term debt: This is assumed to remain constant over time.

Accounts payable: Set at 17% of sales (the average value from 1978–1983).

Advances and other liabilities: Assumed constant over this time period.

Long-term debt: This is the plug or balancing figure.

Other assets: This is assumed to remain constant over this time period.

Contributed capital: Assumed to remain constant over this time period.

Retained earnings: Assumed to increase with net income (MCI is assumed to not pay any dividends).