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.
Modern American wants to acquire ModoUnico. It offers 5,500,000 shares of Modern American, with a current market value of $200,000 and a 10% premium on ModoUnico's shares, for all of ModoUnico's shares.
| Company |
P/E ratio |
Number of shares |
Market value per share |
Earnings |
EPS |
Total Market Value |
| ModoUnico |
20 |
10,000,000 |
$20.00 |
$10,000,000 |
$1.00 |
$200,000,000 |
| Modern American |
40 |
10,000,000 |
$40.00 |
$10,000,000 |
$1.00 |
$400,000,000 |
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 40, 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 uch would Modern American stock price increase?
g. Assume that the new market takes a negative view of the acquisitckion and lowers Modern American's P/E ratio to 30. What would be the new market price per share of stock? What would be its percentage loss?