Case 27: McLeodUSA Long-Term Investment Decision: Optimal Capital Structure The recent growth of McLeodUSA prompted the firm once again to go into the financial markets and file a registration statement for another $400 million in 10-year senior notes. This move represents the fifth time in the last 27 months that McLeod has borrowed in the private debt market raising over $1.125 billion. The reason for the offering was given as a need to raise capital to fund continued expansion in the area of intracity fiber optic networks. Acquisitions, joint ventures, and other strategic alliances have been the source of capital usage in the past and McLeod will certainly keep these types of options open in the future. With such a great need for outside capital, McLeod has decided to fully investigate their optimal capital structure. As such, they have decided to gather data to help analysts with the necessary calculations. Table 1 provides expected levels of earnings per share (EPS), standard deviation in EPS, and estimated required rates of return associated with each capital structure scenario. Table 1 Debt Rati o Expect ed EPS Standard Deviation of EPS Estimated Required Rate of Return 0% $0.38 $0.21 10.3% 10% $0.43 $0.26 10.6% 20% $0.49 $0.33 11.4% 30% $0.55 $0.45 12.2% 40% $0.60 $0.62 13.4% 50% $0.52 $0.84 16.7% 60% $0.41 $1.08 20.6% Questions 1. Calculate the coefficient of variation in EPS for each of the seven debt scenarios using the data in Table 1.
Case 27: McLeodUSALong-Term Investment Decision: Optimal Capital
StructureThe recent growth of McLeodUSA prompted the firm once
again to go into the financial markets and file a registration
statement for another $400 million in 10-year senior notes This
mo!e represents the fifth time in the last "# months that McLeod
has $orrowed in the pri!ate de$t market raising o!er $11"%
$illionThe reason for the offering was gi!en as a need to raise
capital to f&nd contin&ed e'pansion in the area of
intracity fi$er optic networks Ac(&isitions) *oint
!ent&res) and other strategic alliances ha!e $een the
so&rce of capital &sage in the past and McLeod will
certainly keep these types of options open in the
f&t&re+ith s&ch a great need for o&tside capital)
McLeod has decided to f&lly in!estigate their optimal capital
str&ct&re As s&ch) they ha!e decided to gather data to
help analysts with the necessary calc&lations Ta$le 1 pro!ides
e'pected le!els of earnings per share ,-.S/) standard de!iation in
-.S) and estimated re(&ired rates of ret&rn associated with
each capital str&ct&re scenarioTale
!DebtRatioExpectedEPSStandard Deviationof EPSEstimated Required
Rateof Return0% $0.38 $0.2 0.3%0% $0.!3 $0.2" 0."%20% $0.!# $0.33
.!%30% $0.$$ $0.!$ 2.2%!0% $0."0 $0."2 3.!%$0% $0.$2 $0.8! ".%%"0%
$0.! $.08 20."%"uestions1 0alc&late the coefficient of
!ariation in -.S for each of the se!en de$t scenarios &sing the
data in Ta$le 1" Using the 1ero-growth !al&ation model)
calc&late the estimated stock price of McLeod &nder each of
the se!en de$t scenarios2 +hat are the two simplifying
ass&mptions that the 1ero-growth !al&ation model makes34
4ased on the 1ero-growth !al&ation model) what is McLeod5s
optimal le!el of de$t3% 6ote from Ta$le 1 that e'pected -.S are
ma'imi1ed at a de$t le!el of 407 8oes this optim&m agree with
the optimal capital str&ct&re deri!ed from the 1ero-growth
!al&ation model3 +hich of the two sho&ld McLeod $e more
concerned with ma'imi1ing3 -'plain
