Question

Quisco Systems has 6.5 million shares outstanding and a share price of $18. Quisco is considering developing 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) of Quisco 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 on Quisco’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. What effect would the acquisition have on Quisco’s EPS thisyear?

C. Which method of acquiring the technology has a smaller impact on earning? Is this method cheaper? Explain.

Answer 1

Answer:

a. If Quisco develops the product in house, its earnings would fall by $500 × (1 – 35%) = $325 million.  With no change to the number of shares outstanding, its EPS would decrease by   to $0.75. (Assume the new product would not change this year’s revenues.)

b. If Quisco acquires the technology for $900 million worth of its stock, it will issue $900 / 18 = 50 million new shares.  Since earnings without this transaction are $0.80 × 6.5 billion = $5.2 billion, its EPS with the purchase is .

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 is not a good measure of the expense.  In addition, note that because the acquisition permanently increases the number of shares outstanding, it will reduce Quisco’s earnings per share in future years as well.

Explanation:

a. If Quisco develops the product in house, its earnings would fall by $500 × (1 – 35%) = $325 million.  With no change to the number of shares outstanding, its EPS would decrease by   to $0.75. (Assume the new product would not change this year’s revenues.)

b. If Quisco acquires the technology for $900 million worth of its stock, it will issue $900 / 18 = 50 million new shares.  Since earnings without this transaction are $0.80 × 6.5 billion = $5.2 billion, its EPS with the purchase is .

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 is not a good measure of the expense.  In addition, note that because the acquisition permanently increases the number of shares outstanding, it will reduce Quisco’s earnings per share in future years as well.