MCI Communications Corp. 1983 Case Solution

1. Introduction

As the date for AT&T’s settlement decision draws near, the level of uncertainty in the telecommunications industry increases, especially for MCI Communications. The decision will open a plethora of new growth opportunities for MCI Communications but will also undermine its competitive edge against the giant. Up until now, the company has been financing its growth using high-cost loans and debentures; however, with the advent reduction in the costs of its main competitor (AT&T), the company has to be more conservative regarding the financing costs.

2. Projected Cash Requirements

The timing and length of financing will also affect the decision for the optimal financing method. For this purpose, it is necessary that future cash requirements be forecasted. The pro-forma cash flow statement (given below) explains two things. First, the amount of cash required and its timing, and second, the expected length of time before which the company begins generating surplus funds. The amount of surplus funds and their timing will determine the company’s repayment capability.

The forecast has been made using the assumptions of the financial analyst valuing the company. The interstate long-distance market, currently worth $26 billion, is expected to grow at a rate of 10% annually. MCI’s share of this market is expected to grow from 4% them in 1983 to 20% in 1990. 10% of this revenue is expected to come from other than the long-distance market. On the other hand, as per FCC intentions, the access line charges are expected to grow to twice their costs in 1983 and then stabilize at 26.5% of total revenue.

Net margins are expected to squeeze, in the beginning in lieu of rising access line charges, and increasing competition from AT&T. However, as time progresses they are expected to rise to 15% (by 1993) as the access charges stabilize and competition dampens. Since the forecast has been made assuming no additional financing, the interest payments have been projected at their current levels. This will change if additional financing is made using interest-based instruments, like debentures or credit lines.

Other income has been projected using the free cash available currently. As capital requirement use this free cash up, these interest earnings are expected to decline to $3 million and then change depending on sales. Income tax provision, created as a result of recurring losses in the past, is reduced at the rate of 25% if the net income. This rate takes into account all of the tax credits and rebates available to the company. The rate is expected to increase as the growth slows down.

Replacement of old equipment is expected to become routine once equipment begins to age (the year 1986 onwards). This expenditure is expected to increase as well since the value of total equipment is increasing. Investment in equipment is expected to increase to accommodate for growth in sales volume (due to increasing market share), which would require more equipment to handle. As a result, the annual depreciation charge will also increase. The networking capital is expected to remain constant which will result in no change in working capital requirements.

Given the assumptions mentioned, the resulting cash flow requirements are shown by the graph below:

It is obvious that the years 1983 through 1988 have large cash flow deficits, and require external financing to sustain the growth. The year 1989 is the first year to yield a positive cash flow, which increases in the subsequent years. These cash flows can help in the repayment of debt.

3. Financial Policy

Currently, the company is focusing on convertible securities or equity issues in order to create an equity base, against which it can issue the loan in the future (if it has to). This is important because the company is growing fast and requires external financing on a regular basis. Since getting a loan from a financial institution is the fastest way to get such financing, the company has to maintain an acceptable debt to equity ratio in order to make themselves more attractive in institutions’ eyes.

This shows a clear preference for the company for quick financing. This is made even more evident by the fact that the company has issued expensive financial securities (compared to the market rates at the time) in order to ensure a steady flow of funds.