Question

Quisco Systems has 6.1 billion shares outstanding and a share price of $ 18.02. Quisco is considering developing a new networking product in house at a cost of $ 500 million.​ Alternatively, Quisco can acquire a firm that already has the technology for $ 920 million worth​ (at the current​ price) of Quisco stock. Suppose that absent the expense of the new​ technology, Quisco will have EPS of $ 0.78.

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

a. Additional cost incurred on new technology = $500 million, Tax rate = 35%

Current Net income = Current EPS x no of shares outstanding = 0.78 x 6.1 billion = 4.758 billion = 4.758 x 1000 million = 4758 million

New net income = Current net income - Additional cost incurred on new technology(1-tax rate) = 4758 - 500(1-35%) = 4758 - 325 = $4433 million = (4433/1000) billion = 4.433 billion

New EPS = New net income / No of shares outstanding = 4.433 billion / 6.1 billion = $0.726721

Change in net income = New EPS - Current EPS = 0.726721 - 0.78 = -$0.053279

Hence EPS would decrease by $0.053279

b. Cost of firm = $920 million = 920000000 , Price of Quisco system stock = $18.02

No of shares issued = Cost of firm / Price of Quisco system stock = 920000000 / 18.02 = 51054384.02 shares = 51054385 (rounded to next whole number as shares cannot be in decimals)

New no of shares outstanding = Existing no of shares outstanding + No of shares issued = 6.1 billion + 51054385 = 6100000000 + 51054385 = 6151054385 = 6151.054385 million shares

As net income does not change due to acquisition of the firm, therefore

New EPS = Current Net income / New no of shares outstanding = 4758 million / 6151.054385 million = 0.773525

Change in EPS = 0.773525 - 0.78 = -0.006475

c.   Acquisition of firm results in smaller decrease in EPS of Quisco systems. Hence acquisition of firm has less impact on earnings as compared to developing the technology. On the other hand developing a new networking product in house costs less as compared to acquiring the firm.. This is because one time expense on developing the technology will have impact of reducing the earnings and impacting the EPS in current year only. It will also provide tax benefit. Affect on Earnings of company cannot be evaluated only on the basis of expenses. Whereas acquisition will permanently increase the shares outstanding and will decrease the EPS in future years. Hence acquiring the firm is not cheaper.