Question

Quisco Systems has 6.7billion shares outstanding and a share price of $ 17.94Quisco is considering developing a new networking product in house at a cost of $ 504million.​ Alternatively, Quisco can acquire a firm that already has the technology for $ 923million worth​ (at the current​ price) of Quisco stock. Suppose that absent the expense of the new​ technology, Quisco will have EPS of $ 0.66.

a. Suppose Quisco develops the product in house. What impact would the development cost have on​ Quisco's EPS? Assume all costs are incurred this year and are treated as an​ R&D expense,​ Quisco's tax rate is 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.

Answer 1

Given,

Shares outstanding = 6.7billion

Share price = $ 17.94

Quisco EPS o= $ 0.66.

Now, Lets answer to the given questions,

Anwer a) . Suppose Quisco develops the product in house, then in house at a cost = $ 504million which will be deducted from the PBT of the company and will be consider as expense for the current year only.

Lets calculate the Net Income from the given EPS and shares outstanding.

EPS = $ 0.66

Shares Outstanding = 6.7 billion

Net Income = EPS * Shares Outstanding

= 0.66 * 6.7 = 4.42 billion

Net Income has arrived after deducting tax @ 35%

At 35% tax rate, deducted tax = 2.38 billion (Calculation is done by considering the Net Income at 65% and Tax as X at 35%)

PBT = Net Income + Tax

= 4.42 + 2.38 = 6.8 billion

Now, R&D in house cost will be deducted from PBT i.e $ 504million will be deducted from $ 6.8 billion

New PBT = 6.8 - 0.504 = 6.296 billion

New Net Income = New PBT - Tax @ 35%

=6.296 - (6.296*35%) = 4.09 billion

and

EPS = Net Income/ Shares Outstanding = 4.09/6.7 = 0.61

Quisco's EPS wiil be decrease from 0.66 to 0.61 with assumption of all costs are incurred this year and are treated as an​ R&D expense with​ Quisco's tax rate is 35 % and the number of shares outstanding is unchanged.

Answer b). Suppose Quisco does not develop the product in house but instead acquires the technology.

​Alternatively, Quisco can acquire a firm that already has the technology = $ 923million worth​ (at the current​ price) of Quisco stock.

Hence, new shares will be issue at   $ 17.94 to finance the project

Therefore,

New Shares Issue = Acquisition Cost / Share Price

New Shares Issue = 923 million/17.94

= 51.44 millions new share need to issue which will increase the total outstanding,

New Shares Outstanding = Old Shares Outstading + New issue shares

= 6.7 billions + 51.44 millions

= (6.7 + 0.05144) billions

=6.751 billion

New EPS = Net Income / New Shares Outstanding

= 4.42 / 6.751

New EPS = 0.65

We have assume here, as given in the quesion that 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.

Anwer c. From above two methods, one can observe that inhouse cost has major impact on EPS as compared to the acquisition made through the Equity though inhouse cost is much cheaper than the acquisition cost. This happens due to share price of the company is trading at the premium of it cost of capital hence acquisition method has lesser impact on EPS hence this is cheaper than inhouse cost.