Japanese Companies Tend to Belong to Groups ("Keiretsu") and to Hold

Essay

Japanese companies tend to belong to groups ("keiretsu") and to hold shares of one another. Because these cross-holdings are minority interests, they tend not to be consolidated in published financial statements. To study the impact of this tradition on published earnings, take the following simplified example:
Company A owns 20% of Company B; the initial investment was 20 billion yen.
Company B owns 30% of Company A; the initial investment was 20 billion yen.
Both companies value their minority interests at historical cost. The year-end nonconsolidated balance sheets of the two companies follow:
$$\begin{array} { l c c } \text { Eolance Sheet } & \begin{array} { c } \text { Company A } \\\text { Yen Eillion }\end{array} & \begin{array} { c } \text { Company B } \\\text { Yen Eillion }\end{array} \\\hline \text { Current Assets } & 70 & 120 \\\text { Fixed Assets } & 70 & 150 \\\text { Minarity Investments } & \underline { 10 } & \underline { 10 } \\\text { Total Assets } & 150 & 280 \\\text { Debt } & 50 & 90 \\\text { Shareholders Equity } & \underline { 100 } & \underline { 200 } \\\text { Total Liabilities } & 150 & 280 \\\hline\end{array}$$ The annual net income of Company A was 15 billion yen. The annual net income of Company B was 40 billion yen. Assume that the two companies do not pay any dividends. The current stock market values are 250 billion yen for Company A and 550 billion yen for Company B.
a. Restate the earnings of the two companies, using the equity method of consolidation. Remember that the share of the minority-interest profits is consolidated on a one-line basis, proportionate to the share of the equity owned by the parent. The value of the investment in the subsidiary is adjusted to reflect the change in the subsidiary's equity.
b. Calculate the P/E ratios based on nonconsolidated and consolidated earnings. Are they similar?