Question

Quisco Systems has 6.5 millionshares outstanding and a share price of $18. Quisco is consideringdeveloping a new networking product in house at a cost of $500million. Alternatively Quisco can acquire a firm that alreadyhas the technology for $900 million worth (at the current price) ofQuisco stock. Suppose that absent the expense of the newtechnology, Quisco will have an EPS of $0.80.
a. Suppose Quisco develops theproduct in house. What impact would the development cost have onQuisco’s EPS. Assume all costs are are incurred this year.andare treated as an R&D expense. Quisco’s tax rate is35%, and the number of shares outstanding is unchanged.
b. Suppose Quisco does not developthe product in house but instead acquire the technology. Whateffect would the acquisition have on Quisco’s EPS thisyear?
c. Which method of acquiring thetechnology has a smaller impact on earning? Is this method cheaper?Explain.

Answer 1

Answer:

a. The EPS would drop from $6.954 to $(43.046)

b. The EPS would drop from $0.8 to $6.954

c. Firm acquisition will has smaller impact on earning. However, it is not necessary that it is a cheaper method as the firm has to issue a big amount of new shares to new shareholders ( 50 million shares issue in comparison of 6.5 million oustanding shares) which diluted EPS of current shareholders causing potential problem in Corporate Governance ( e.g: new shareholders with substantial voting rights may ask for the re-election of BOD).  

Explanation:

As Quisco System acquires new firm, it will have to issue 50 million new shares ( $900 million / $18), resulting in EPS of $0.8 => Total after-tax earning of the  company this year with the absence of R&D expenses is $45.2 million ( 0.8 x (56.5 million outstanding shares). => Current year EPS is $6.954 ($45.2 million/6.5 million outstanding shares)

Thus:

+ With the product development through other firm acquisition, Quisco will keep a positive EPS at $0.8 with 56 million outstanding shares.

+ With product development in-house chosen, the R&D expenses will be booked as expenses this year ( as it is uncertain the R&D will bring future benefit yet it is not capitalized), Quisco System's earning would be: $45.2 million - $500 million x (1- 35%) =  -$279.8 million => EPS = -279.8 million / 6.5 million shares = $(43.046).