Reference no: EM131907364

The fiber-optic communications firm PSINet went public in 1995 and raised $46 million. Shortly thereafter, PSINet began to serve business customers as well, establishing 100,000 business accounts in 27 countries. They under-took a strategy to run one of the world’s largest networks, linked to a massive number of PSINet-owned Web-hosting centers. During this time, PSINet’s debt load increased 36-fold, from $112 million to $4 billion. Its annual interest obligation went from being $5 million in 1997 to being $400 million in 2000. In April 1998, for the first time in its history, PSINet issued debt that was below investment grade(junk), selling $600 million in bond paying 10 percent. The firm then made a series of large investments: It spent $34 million for new headquarters, purchased a corporate jet, and agreed to pay $90 million in order to have the new Baltimore Ravens football stadium bear its name. The cover story in the May 28, 2001, issue of the Forbes magazine describes how PSINet’s CEO, William Schrader, and its board of directors assessed the firm’s financing strategy. “We knew we were going to be heavy on the debt side, light on the equity side,” says William Baumer, a board member and an economist who heads the University of Buffalo’s philosophy department. “The assessment was that the debt markets are wide open, the equity markets not as good, and if we are successful here, we won’t have any trouble retiring this debt.” Schrader insists Wall Street would have been cool to additional stock offerings, despite PSINet’s lofty price. “Wall Street says when you can raise equity,” he claims. In the two years leading to the peak of the technology bebble in March 2000, PSINet’s stock price rose from $7 to $60. Between 1997 and 2000, PSINet made 76 acquisitions. After a period of very rapid growth in the second half of the 1990s, the telecommunications sector began a sharp decline to default on its $400 billion debt. It missed a $20 million interest payment and announced that it would likely seek bankruptcy protection. Its stock fell to 18 cents a share and was delisted. PSINet’s CEO and founder, William Schrader, resigned in May 2001. The Forbes story contains an interesting description of Schrader, stating that “implacable self-confidence helped Bill Schrader transform a few leased phone lines into a sprawling global network.” 1) Was the main factor driving PSINet’s capital structure (a) the tradeoff between tax shields and costs of financial distress, (b) asymmetric information, (c) its cash position, or (d) perceived mispricing? 2)Did PSINet’s manager use a financing pecking order? 3) Did PSINet’s cash position affect its investment policy? 4) Was PSINet’s chief executive officer overconfident, and did he believe that PSINet’s equity was undervalued?