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Examine the specific proposal to issue $2bn new debt and use it to repurchase shares.
To examine this specific proposal by MCI Communications Corporation we must first understand the theory behind Capital Structure and what it means in this context. Capital Structure refers to the way a company chooses to finance their assets through a combination of equity and debt, both short and long-term. MCI were experiencing slow growth and a sluggish share price performance in an otherwise buoyant market. This can be seen in the case study in Exhibit 1. MCI’s share price performance was below that of the S&P 500 in the period shown. They also failed to match the performance of their competitor American Telecom. This led to restlessness amongst the shareholders. It is clear that this firm was affected by the agency problem. This is when there is conflict between manager’s aims and those of shareholders and so the management feels obliged to do something. As a result Gavin Phillips, a long-time company director, proposed a program to repurchase some of the company’s outstanding common stock by increasing their debt financing. With a repurchase of shares a company buys back its own shares from the marketplace, reducing the number of outstanding shares. The idea of the proposal was to send a bold signal to the market signifying MCI’s confidence in their stock. They are effectively saying that they find no better investment than their own company.
It seemed that the board of directors at MCI was divided between two possible solutions. Gavin Phillips suggested financing the repurchase by increasing the debt to equity ratio within the company from its current ...