Corporate Governance: Overstating Earnings. During the 1960s, many conglomerates were created by firms that were enjoying a high price/earnings ratio (P/E). These firms then used their highly valued stock to acquire other firms that had lower P/E ratios, usually in unrelated domestic industries. Conglomerates went out of fashion during the 1980s when they lost their high P/E ratios, thus making it more difficult to find other firms with lower P/E ratios to acquire.

During the 1990s, the same acquisition strategy was possible for firms located in countries where high P/E ratios were common compared to firms in other countries where low P/E ratios were common. Consider the hypothetical firms in the pharmaceutical industry shown in the table below. (Click on the

icon to import the table into a spreadsheet.)

Modern American wants to acquire ModoUnico. It offers 5,500,000

shares of Modern American, with a current market value of $210,000,000 and a 10%

premium on ModoUnico's shares, for all of ModoUnico's shares.

		Number	Market value			Total
Company	P/E ratio	of shares	per share	Earnings	EPS	Market Value
ModoUnico	21	10,000,000	$21.00	$10,000,000	$1.00	$210,000,000
Modern American	42	10,000,000	$42.00	$10,000,000	$1.00	$420,000,000

a. How many shares would Modern American have outstanding after the acquisition of ModoUnico?

b. What would be the consolidated earnings of the combined Modern American and ModoUnico?

c. Assuming the market continues to capitalize Modern American's earnings at a P/E ratio of

42 ,

what would be the new market value of Modern American?

d. What would be the new earnings per share of Modern American?

e. What would be the new market value of a share of Modern American?

f. How much would Modern American's stock price increase?

g. A number of firms, especially in the United States, have had to lower their previously reported earnings due to accounting errors or fraud. Assume that Modern American had to lower its earnings to

$5,000,000

from the previously reported $10,000,000.

What might be its new market value prior to the acquisition? Could it still do the acquisition?