Quisco Systems has 6.86.8 billion shares outstanding and a share price of $ 18.4
ID: 2786453 • Letter: Q
Question
Quisco Systems has
6.86.8
billion shares outstanding and a share price of
$ 18.48$18.48.
Quisco is considering developing a new networking product in house at a cost of
$ 527$527
million. Alternatively, Quisco can acquire a firm that already has the technology for
$ 887$887
million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of
$ 0.72$0.72.
a. Suppose Quisco develops the product in house. What impact would the development cost have onQuisco's EPS? Assume all costs are incurred this year and are treated as an R&D expense, Quisco's tax rate is
35 %35%,
and the number of shares outstanding is unchanged.
b. Suppose Quisco does not develop the product in house but instead acquires the technology. What effect would the acquisition have on Quisco's EPS this year? (Note that acquisition expenses do not appear directly on the income statement.
Assume the firm was acquired at the start of the year and has no revenues or expenses of its own, so that the only effect on EPS is due to the change in the number of shares outstanding.)
c. Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain.
Explanation / Answer
a. If the product is developed in house then earnings would fall byan amount equal to = $527 million*(1-35%) = $342.55 million
Assuming no change in no. of shares outstanding, decrease in EPS would be: $342.55 million/6,800 million shares = $0.05
Thus new EPS = $0.72-$0.05 = $0.67
b. Amount of new technology = $887 million. Thus no. of stock to be issued = $887 million/$18.48 per share = 48 million new shares.
Earnings without this transaction = $0.72*6.8 billion shares = $4.9 billion.
Thus EPS with purchase = 4.9/6.8 = $0.72
c. Acquiring the technology would have a smaller impact on earnings, but this method is not cheaper.Developing it in-house is less costly and provides an immediate tax benefit. The earnings impact isnot a good measure of the expense. In addition, note that because the acquisition permanentlyincreases the number of shares outstanding, it will reduce Quisco’s earnings per share in futureyears as well.
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