McI - Corporate Finance

Question 1:

After MCI’s IPO in 1972, the stock price dropped due to a financial distress in 1975. MCI was forced to issue new equity to survive. MCI then used leasing as the main source of financing. One advantage of leasing was the lesser could enjoy the tax benefits. In 1978, MCI issued convertible preferred stocks. The robust growth of the revenue and a positive expectation of the firm made the convertible preferred stocks fairly attractive. MCI forced these issues to be converted within six months to two years. MCI preferred convertibles to common equity because issuance of new common equity was considered negative signaling of an overestimation of the shares. However, issuance of convertibles was considered positive signaling, since investors would be protected as debt holders when company’s value dropped and become shareholders when company appreciates. In 1981, MCI switched from convertible preferred stocks to convertible debt. This is because MCI had a tax loss carry-forward and could benefit from the tax shield.

Question 2:

Question 3:

The firm should continue issuing convertible bonds and force the investors to convert them within a period. This is because MCI’s debt ratio (55%) is significantly higher than the industry average (~40%), and if MCI gets rated by a rating agency, it would probably be rated fairly poor so that the financing cost would increase for debt issuance. However, equity issuance is bad signaling and would hurt investors’ expectation of MCI’s promising future. MCI faces huge growth opportunity and needs about $3.5 billion dollars in 1988 to realize this potential. Therefore, it needs an efficient way to raise money which will also not significantly lever up the company. Therefore, MCI should continue to issue convertible bonds and force the investors to convert them within a predetermined period.