Question

Cisco Systems has 8.6 billion shares outstanding and a share price of $29. Cisco is considering developing a new networking product in a house at a cost of $629 million. Alternatively, Cisco can acquire a firm that already has the technology for $904 million worth (at the current price) of Cisco stock. Suppose that absent the expense of the new technology, Cisco will have EPS of $0.87.

a.) Suppose Cisco develops the product in-house. What impact would the development cost have on Cisco's EPS? Assume all costs are incurred this year and are treated as R&D expenses, Cisco's tax rate is 35%, and the number of shares outstanding is unchanged. The EPS if developed in house is (round to the nearest cent.)

b.) Suppose Cisco does not develop the product in-house, but instead acquires the technology. What effect would the acquisition have on Cisco'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.)

The EPS if acquired is  (round to three decimal places.)

c.) Which method of acquiring the technology has a smaller impact on eamings? Is this method cheaper?

( )would have a smaller impact on earnings. (Fill in either "Purchasing" or "In-house")

The cheaper method of acquiring technology is ( ). (Fill in either "Purchasing" or "In-house")

Answer 1

Answer (a):

Absent the expense of the new technology, Cisco will have EPS = $0.87.

If developed in-house R&D Expense = $629 million

Impact on net profit (Reduction), net of tax = 629 * (1 - 35%) = $408.85 million

Number of shares outstanding = 8.6 billion = 8,600 million

Reduction in EPS = 408.85 /8600 = $0.05

Hence:

EPS if developed in house is = $0.87 - $0.05 = $0.82

EPS if developed in house is = $0.82

Answer (b):

Share price = $29

Acquire a firm that already has the technology for amount = $904 million

Number of new shares to be issued to acquire = 904000000 / 29 = 31,172,413.79

Total number of outstanding shares post acquisition = 8600,000,000 + 31,172,413.79 = 8631,172,413.79

The EPS if acquired is = (8600,000,000 * $0.87) / 8631,172,413.79 = $0.867

The EPS if acquired is = $0.867

Answer (c):

From answers (a) and (b) above:

EPS if developed in house is = $0.82

EPS if acquired is = $0.867

As such:

"Purchasing" would have a smaller impact on earnings

The cheaper method of acquiring technology is "Purchasing"