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Impact of the Share Buy-Back on McI’s

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Essay title: Impact of the Share Buy-Back on McI’s

1.) Impact of the share buy-back on MCI’s:

a) Shares outstanding

Assumptions

􀂃 The assumption is made, that MCI exactly offers 2 billion $ of long-term

debt to finance its stock repurchase program and double its debt/equity ratio

(book value) from approximately 36% to 72%.

􀂃 For the immediate buy-back of a large amount of shares MCI has to make a

tender offer for its own shares. It is assumed, that a premium of 10%

over the current share price, which results in a buy-back of $30.53 per

share.

Results

With these assumptions MCI is able to buy back 65.52 million shares for its

2 billion $ of new long-term debt, resulting in the reduction of the number of

outstanding shares from formerly 687 million to 621.48 million shares.

Thereby has to be noted that the figures in the case study differ: In MCI’s

Income Statement the weighted-average number of common shares is stated

with 687 million (see case Exhibit 4, p. 360), and in the comparables sheet the

number of shares is noted as 681 million (see case Exhibit 2, page 358). In all

our further calculations we use the figure from MCI’s income statement and

calculate with 687 million shares outstanding, as both figures are from the

same time frame (year-end 1995), but the one directly from MCI should be

more reliable.

Sensitivity Analysis

In order to account for the uncertainty in estimating the premium MCI will pay

in its tender offer, we did a sensitivity analysis and changed the buy-back

premium from 10% to 5% and 15%, respectively. With these premiums, MCI

is able to buy-back 68.64 (5% premium) and 62.67 (15% premium) million

shares, which results in a reduction to 618.36 and 624.33 million

outstanding shares, respectively. This result is obvious, the higher the

premium the lower the amount of shares bought back and the number of

shares remaining. For further details please see our calculations in the

appendix.

b) Book value of equity

The issuance of 2,000 million $ of long-term debt and the repurchase of

shares for this amount results always in a reduction of the book value of

equity from formerly 9,602 million $ of stockholders’ equity (information from

MCI’s balance sheet year-end 1995) to 7,602 million $.

This result is irrespective to the accounting method chosen by MCI. In

general, there exist two methods to account for share repurchases: the

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treasury method and the share retirement method (one could also use a

mixture of both).

In the treasury method, the shares repurchased and held as treasury shares

are measured and carried at the cost of repurchase irrespective of the

subsequent changes in the market price of the shares. In the presentation on

the balance sheet the carrying amount of the repurchased shares (in MCI’s

case this would be 2,000 million $) is set off against stockholders’ equity (in

MCI’s case this is 9,602 million $). The reduction of the stockholders’ equity is

accounted for in a reduction of the share premium account (in MCI’s case by

2,000 million $), and if this account is exceeded the remaining amount is

deducted from any other reserves (e.g.

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