Conway Industries Corporation Page 1 of 5

Conway Industries Corporation:

The NetSet4 Project

The board of directors of the Conway Industries Corporation, like those of most very large companies,
consists of two groups. First, there are "inside directors," headed by the chairman, vice-chairman, and
president, who are full-time employees of the corporation and who comprise the top management of
the firm. Second, there are "outside directors" who provide different perspectives to management and
who represent various constituents, especially various groups of stockholders. Conway Industries
outside directors include an investment banker, two commercial bankers, the presidents and chairmen
of five NYSE listed companies, and the presidents of a large life insurance company, a major foundation,
and a major university (this director is a former finance professor).

The role of the outside directors, all of whom are both very compe tent and very independent
individuals, is to help management make better decisions about major corporate policies, including
strategic decisions such as whether or not to move into new ventures. In order to maintain a degree of
independence, and to avoid unconsciously biasing the outsiders' views, the corporation has provided
the outside directors with a budget to hire outside consultants to assist these directors in making
appraisals of various proposed corporate actions. Obviously, the outside directors must have access to
all corporate information, but they are permitted—and even encouraged—to play the role of devil's
advocate in the decision process.

Recently Conway Industries has been studying the question of whether or not to undertake just such a
major strategic investment. A proposal has come to the board of directors that would involve the
manufacturing, distribution, and servicing of "NetSet4," which are small but very sophisticated portable
computer, “an internet of things” hub that can serve as: (1) a very, powerful personal computer, (2)
an input/output device for communicating with other computers , (3) a media hub and
combination of cable TV and (4) a regular telephone, a room speaker, and call forwarding. This product
is a spin off from development work done on aircraft electronics and control systems, but it is not in a
"mainline" business segment of the company. Hence, management decided that the best course of
action, assuming that Conway Industries decides to proceed with the project, would be to form a
new subsidiary.

The NetSet4 terminals are targeted to have a sales price of $3,000, the midpoint of the price range
considered by knowledgeable observers to be reasonable in the market segment Conway Industries
desires to serve. On the basis of some preliminary but thorough studies, the best estimates by the
marketing research group are, that with this selling price, there is a 0.1 probability that sales will be
750,000 units per year, a 0.3 chance of sales of 1,000,000 units, and 0.6 that sales will be 1,250,000 units.
Variable production / distribution / servicing costs are estimated at $ 1 , 000 per unit in the projected
output range. The subsidiary's fixed operating costs per year, including both amortization of
development costs and maintenance of the data processing system, are estimated at $1.5 billion. An
initial investment of $3 billion would be required to set up manufacturing plants, develop the required
software, and make the system operational. The proposed new company's effective tax rate would be
40 percent.

Because of the risks involved, management's tentative plans call for raising the entire $3 billion as
common equity. Conway Industries would supply $1.5 billion of the equity, with the remainder being
raised by selling stock to the public. Thus, if Conway Industries were to go ahead with the project, it
would own a half-interest in a new, all-equity-financed subsidiary.

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Conway Industries Corporation Page 2 of 5

Conway Industries management has recommended to the board of directors that the NetSet4 project,
as outlined here, be accepted. However, because of the magnitude of the project and its importance
to the corporation, the outside directors have concluded that they should consider it carefully before
authorizing management to go forward. Therefore, they have employed the firm of Joiner & Peacock to
make an appraisal of the project to see whether it has any obvious flaws. Joiner & Peacock is not
expected to conduct a complete analysis, or to make a definite go or no-go recommendation. Rather,
their task is to help the outside directors “ask the right questions” of the management and to ensure
that these questions are answered properly before the final decision is reached.

One of the outside directors, Herbert Linville, the former finance professor who is now a university
president, has been appointed by the other outside directors to work with Mildred Schwartz, the
Joiner & Peacock partner in charge of the project. Linville and Schwartz decided to start their
investigation by looking first into some of the operating leverage characteristics of the proposed
subsidiary and then turning their main attention to the question of how the new subsidiary should be
financed.

Conway Industries management has stated that it thinks an all-equity capital structure is best because
of the risks inherent in a new company, producing a new product. However, Linville and Schwartz note
that most electronics manufacturers, including those that produce telephone and data processing
equipment, use fairly large amounts of debt to finance their operations, with target debt/assets ratios
generally falling in the range of 20 to 40 percent. Further, the investment banker on the Conway
Industries board, Clarke Cutler, estimates that if the new subsidiary raises up to 20 percent of its
required capital (or $600 million) as debt, the bond issue would be rated Aaa and would carry an
interest rate of 12 percent. If the debt/assets ratio were increased to as much as 40 percent, the
bonds would be rated Baa and would have an interest rate of 14 percent under current market
conditions. At a debt/assets ratio between these extremes, the bond rating—and consequently the
interest rate—would take an intermediate position.

Based on Joiner & Peacock's in-house research, it appears that the cost-of-equity can be estimated
by the following equation:

ks = RF + a1 (beta) + a2 (σROE).

According to these in-house empirical studies, a reasonable proxy for the risk-free rate is the yield on
treasury bonds, currently 11 percent, and the "best fit" values for the constant terms are a 1 = 2.0 and a2
= 0.3. It is also estimated that for this type of business, a beta of 1.0 is reasonable if the company has no
debt. The value of σROE for use in this equation can be calculated easily from the data given. Thus, the
equation for the cost-of-equity, assuming an all-equity capital structure, is:

ks = 11% + 2.0 (1.0) + 0.3 (σROE).

Clearly, the new subsidiary's cost-of-equity would be higher if it uses debt than if it does not. However,
to use the above equation when debt is employed, new values for σROE and the beta coefficient are
required. It is not difficult to incorporate debt into the income computation, so calculat ing the impact
of debt financing on the standard deviation of ROE is straightforward. However, finding an adjusted
beta coefficient is more of a challenge. As a first approximation, Joiner & Peacock assume that a
leveraged firm's beta can be estimated as follows:

bL = b u [l + (1 - t) (Debt/Equity)]

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Conway Industries Corporation Page 3 of 5

where bL and b u are the betas of leveraged and unleveraged firms; t is the corporate tax rate, and debt
and equity are measured at book value. 1 Therefore, if Conway Industries uses 20 percent debt financing,
then, as an approximation,

bL = 1.0[l + (0.6) (0.25)] = 1.15.

At 40 percent financing, the subsidiary's estimated beta would be 1.40.

Linville and Schwartz gathered the preceding information and were confident that they soon would
be able to penetrate to the heart of the matter. They then developed the following set of questions,
and you, as a junior member of the consulting firm and Schwartz's assistant, must supply "first
approximation" answers to them.

QUESTIONS

1. What is the breakeven sales volume?

2. What would the new company's rate of return on equity (ROE) be if sales ran at an annual level
of (1) 1,000,000 units, (2) 750,000 units, or (3) 1,250,000 units?

3. Using the formula given above for computing the cost-of-equity, k s, and assuming an all equity
capital structure, calculate the cost-of-equity. Does it appear feasible, in terms of its effects on
Conway Industries stockholders, to set up the new subsidiary to produce the NetSet4?

4. What would expected ROE and σROE be at each of the three debt levels (zero, 20 percent, and
40 percent)? Measuring risk by the standard deviation of ROE (even though the distribution is
not normal), how risky is this project? Is it realistic to assign a zero probability to losses? Assume,
for purposes of this question, that σROE for the average industrial firm is 7 percent, and that the
coefficient of variation of ROE is generally in the 0.5 to 0.6 range.

5. What would the net income (and EPS) breakeven point be if the subsidiary were financed
with (1) 20 percent debt or (2) 40 percent debt, that is, at what levels of unit sales would net
income (and EPS) equal zero under each capital structure?

6. What would the subsidiary's total market value and total equity value be if it were financed (1)
by equity only, (2) with $600 million of debt, plus equity, or (3) with $1.2 billion of debt, plus
equity? Work with the expected (EBIT), plus information developed earlier, and use these
formulas:

( EBIT )  kd D )(1  t )
V  D , and
ks

S=V–D

Here V is the total market value of the firm, D is total debt, and S is the total stock value.

1
This equation is based on a theoretical model developed by Professor Robert Hamada ("The Effect of the
Firm's Capital Structure on the Systematic Risk of Common Stocks," Journal of Finance, May 1972).
Hamada's equation actually measures debt and equity not at book value but at market. For a new firm, these
values are likely to be similar, though not identical.
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Conway Industries Corporation Page 4 of 5

7. Linville and Schwartz have told you to assume (1) that Conway Industries wants to own 50
percent of the equity of the subsidiary irrespective of how much debt is used, (2) that the new
subsidiary's initial stock will be sold to the public at $20 per share, and (3) that
Conway Industries can legally purchase its stock at a price other than $20,
providing the public knows of Conway Industries purchase price but is still willing
to pay $20 per share. The $20 price is somewhat arbitrary, but the investment
banker member of Conway Industries board has informed Linville and Schwartz
that, in his opinion, $20 is the best price at which to bring out a new issue in order
to maximize the total value of the firm. A low price, such as $1, or a high price,
such as $1,000, could be set, but the conventional price is in the $15 to $25
range.

a. How many shares should the new subsidiary have to issue at each of the
three capital structures? (Hint: recognize that P o = $20 = S/N, and n = (V -
D)/P o = S/P o . Here S is the total market value of the stock and N is the
number of shares out standing.)

b. What would Conway Industries initial gain or loss be at each capital

structure?

c. Does it seem fair to permit Conway Industries to buy stock at a price differ ent
from that paid by the general public?

8. What would the expected earnings per share, the coefficient of variation of EPS,
and the expected P/E ratio be under the three financing plans?

9. What is the probability that the subsidiary would be unable to cover its interest
charges, assuming it uses 40 percent debt?

10. We typically think of the firm's stock price as first rising as it begins to use
financial leverage, then hitting a peak, and finally declining if it goes on to use
excessive levels of debt. In this case, the price is assumed to be constant at
$20 per share. Reconcile the typical view of leverage with the situation in this
case.

11. Using the MM-with-tax model, what would the subsidiary's total value and equity
value be at 20 percent and 40 percent debt? (Note: the basic equation is VL =
Vu + tD.)

12. What would the value be at the three debt levels using Miller's for mula?

 (1  t c )(1  t pS ) 
VL  Vu  1   D.
 (1  t pD ) 

Here tc = corporate tax rate, tpS = personal tax rate on stock income (average
dividends and capital gains), and t pD = tax rate on interest income from debt.
Assume that the personal tax rate on interest is t pD = 45 percent, the tax rate on
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stock income (dividends and capital gains) is t pS = 25 percent, and the

corporate tax rate is t c = 40 percent.

13. Give an explanation for the differences in value using the three models.

14. Obviously, the final decision will be based on much more detailed analysis than has been
done here, but, based on the information at hand, should the outside directors recommend
that Conway Industries proceed with the project, and, if so, how should it be financed?

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The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019