koito case

KOITO case study

International Corporate finance and Governance

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KOITO case study

QUESTION 1

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KOITO case study

FINANCIERS AND OWNERS

• Financiers

People providing capital (creditors, etc.). • Banks usually help companies in Japan, a practice not

common in the US. • Some issues that may arise: creditors (those not part of

the structure itself) might be scared of this type of organization as they usually lend money to one company and if this company gives it to one supplier (to help him or for any other reason), this could increase the risk of default.

• There is less control of creditors over the money they lend.

• Owners

People providing equity (shareholders, etc.). “Informal supply contracts”: shareholders might lose stakes in the company they invested in by any type of agreement between the management of the company and any supplier within the keiretsus. Japanese always put forward the idea of loyalty, an idea that is not necessarily respected in the United States (as an example). • Problems especially for an investor from western

countries: contracts are always formal and he/she may fears to lose some of his/her ownership.

• “Reciprocal equity ownership”: owners might not accept any reciprocal agreement as they invest in ONE company, not a group. In addition, the reciprocal company may underperform. In keiretsus the shareholders’ stakes are not the priority (unike in the US) but the other stakeholders (especially employees)as clearly shows a quote by Mr Matsuura: “In our case, we have to consider the interest of our employees, our clients, and the local communities where we operate, as well as those of the shareholders”.

• In joint projects issues might arise: who needs to finance them? Who has the rights over the finished projects?

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KOITO case study

SUPPLIERS AND EMPLOYEES

• Suppliers

Suppliers of goods:• No formal contracts: they may lose opportunities as the

leading company might ask another supplier to provide them with goods needed. In addition the leading company can blackmail the suppliers (ask for lower prices etc.). Suppliers do not have bargaining power (according to Porter’s five forces).

• Due to the idea of loyalty, you are “forced” to provide your leading company (even though it is never on an exclusive basis).

• Employees

“Intercompany personnel transfer”: they might not find that acceptable. • Managers: board composition issues. Example: an

American who has 30% of the shares of a company would insist on board representation but it is not common in keiretsus. In addition the board is not independent in the sense that they depend of the directors of other companies. Example: let’s imagine a decision that would favor employees of company A; the board of directors would not agree on it because it might disadvantage employees from company B.

• Additional information: in Japan you often find lifetime

employees (particularly in keiretsus). This is not necessarily in favor of employees who are “morally forced” to stay with the company.

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KOITO case study

QUESTION 2

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KOITO case study

• T. Boone Pickens’ motives when he bought the shares are: His main motive seems to be that he “intended to greenmail Koito” because of “the high price Mr. Pickens allegedly paid for his stock, as well as his refusal to disclose the source of his stock and its associated financing”.• He was also suspected to be the front man of Mr.

Watanabe or other investors. NB: Mr. Pickens revealed later that “Mr. Watanabe figured that if an outsider were ever going to break through the closed corporate culture it would have to be an American. So (they) met to discuss the possibility of buying into Japan Inc.” Having 10% of the stock during 6 months would allow Mr. Pickens to turn over confidential financial documents that would help him (and then Mr. Watanabe) investigate Toyota’s ties.

• As the largest shareholder of Koito Manufacturing:On March 30, 1990, Mr. Pickens had 26.4% and was allowed to acquire an additional 5 million shares of Koito stock and planned to increase his stake to 30%. In any case he would have less than 34% and would therefore not be able to “propose special shareholders’ resolutions”, the only way to be represented on the board.

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KOITO case study

QUESTION 3

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KOITO case study

• We clearly know that a dividend payment is not a right, it is optional. Some companies like Apple never paid dividends. Therefore the demand for higher dividends is never really justified. However, if the company has a policy of paying dividends, better results should have a positive impact on dividends payment.

• In addition the general tendency of this period in Japan was to pay low dividends. This idea is expressed in a book written by Hidetoshi Yamaji, The Japanese style of

Business Accounting. We found an extract of this book on the Internet. A quote from the book is:

• “In their attempt to stabilize dividends, firms often continue to pay a constant amount (usually five year per share) even when their statutory dividend constraint is binding”. This is the Japanese way of paying dividends. Even though Mr. Pickens base his arguments on proper figures provided by the company, he cannot go against the usual Japanese business model.

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KOITO case study

SOME ARGUMENTS HOWEVER SHOW THAT HIS DEMAND COULD BE JUSTIFIED:

• According to the article “Agency Problems and dividends policies around the world” (1999, la Porta, Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny), the demand seems to be justified because “unless profits are paid out to shareholders they may be diverted by the insiders for personal use or committed to unprofitable projects that provide benefits for the insiders”. Hence, Mr. Pickens might be afraid of any misuse of retained earnings and prefer to receive higher dividends.

• However, some elements show that his demand could have been justified:

1/ First of all, Mr. Pickens does not have more than 20.2% of the shares for more than 6 months in September 1989 (he has to wait for the 4th of October).2/ Therefore, this does not allow him to inspect Koito’s accounting records and to apply to a court to appoint a special auditor for this purpose. 3/ Information provided by the income accounts (exhibit 3) show us that the period from 31/03/1989 to 31/03/1990 was a profitable period and figures increased in comparison with the previous period. Therefore, if he had got access to these documents his demand would have been justified. For example: • Gross profit increases of approximately 3% (from 16,522

to 16,998 yens)• Net income increases of 22% (from 2,871 to 3,677 yens)

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KOITO case study

EMPIRICAL EVIDENCE

Exhibit 5 • We can put forward another interesting figure: Earnings

per share increases from 17.90 to 22.93. • We assume here that both semesters were good.

Consequently, the period from 31/03 to 30/09 was a good period: figures increased substantially in comparison to the previous period.

• Knowing that the semi-annual results published in September 1989 would show an increase of 22% of the net income, we could say that the demand of Mr. Pickens is justified.

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KOITO case study

• The state of the underlying Japanese business environment does not allow Pickens to try to get more dividends. We would recommend him to modify the reported earnings. We deduced that from the same book (Japanese style of business accounting): “Managers may be able to implement discretionary accounting changes and increase reported income to relieve the dividend constraint. (…)

• They may also be able to raise their reported income by selling appreciated fixed assets or security investments to realize gains. Large realized gains from sale and buyback of appreciated lend and securities at current market price can add substantially to reported earnings”. The latter practice is called ekidashi.

• Pickens, could therefore increase the reported earnings (in the accounts) and ask for higher dividends.

• The state of the underlying Japanese business environment does not allow Pickens to try to get more dividends. We would recommend him to modify the reported earnings. We deduced that from the same book (Japanese style of business accounting): “Managers may be able to implement discretionary accounting changes and increase reported income to relieve the dividend constraint. (…) They may also be able to raise their reported income by selling appreciated fixed assets or security investments to realize gains. Large realized gains from sale and buyback of appreciated lend and securities at current market price can add substantially to reported earnings”. The latter practice is called ekidashi.

• Pickens, could therefore increase the reported earnings (in the accounts) and ask for higher dividends.

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KOITO case study

QUESTION 4

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KOITO case study

• Mechanism: Koito’s limited profits result from lower prices for sales to Toyota. Independent suppliers have lower bargaining power, so Toyota prefers to maintain its self-dealing transaction with Koito. The insider from Toyota influenced decisions in favor of Toyota (low buying prices from Koito), which clearly increases Toyota’s profit.

• It is a self-dealing transaction because there is money (value) transferred from Koito to Toyota. The insider has a greater vested interest in insuring the welfare of Toyota than in Koito since Toyota owns only 19% of Koito.

• To summarize, there is a transfer of money from Koito’s other shareholders (81%) to Toyota.

• If Pickens unveils confidential financial documents such as the transactions between Koito and Toyota, he can then prove that the items are underpriced compared to the market.

• Furthermore, if he reveals the confidential information, the markets will react and reflect the cost of the self-dealing transaction for Koito.

• To prove it is a self-dealing transaction, we can scrutinize the income statement and notably the accounts receivable and sales (with details of the prices of the goods sold) to see if there is any difference between Toyota and its competitors and the salary of Koito managers to see if they are not bribed.

• Suggestions to avoid corporate governance issues: • Former executives of companies which belong to the

industrial grouping (keiretsu) – such as assemblers, dealers, sub assemblers and others – should not be allowed access to the board of directors of any of the companies in the same grouping. Furthermore, we suggest that the slate is nominated by shareholders through representative votes to promote monitoring instead of the management itself proposing candidates. Naturally, the biggest shareholders will have the biggest influence for electing directors.

Reference:Financial statement fraud: prevention and detection by Zabihollah Rezaee, Richard Riley

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KOITO case study

QUESTION 5

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KOITO case study

INTRODUCTION QUESTION 5

• In Japan, carmakers have a very high bargaining power (Porter’s five forces). “Japanese carmakers will not pay higher prices for parts of cars”. Therefore, losing an important customer like Toyota (53% of Koito’s revenues) would result in less income unless there are enough other independent carmakers to compensate the loss. This could result in a decrease in stock price (less income + tarnished image).

• We are going to use the Dividend Discount Model with a constant growth of the dividend.

• We are going to follow 5 steps: 1. Calculation of the dividends (constant amount based on

an average over 9 years: from 1982 to 1990). We make previsions on 5 years.

2. Calculation of the ROE. Previsions on 5 years; 3. Calculation of the growth rate: g=ROE*b with b: plowback

ratio and b=1-p with p: payout ratio. 4. r: we use the WACC method with the risk free rate we

found on the internet. We also calculated the tax rate. (www.tradingeconomics.com/japan/government-bond-yield).

5. Supposing that the growth of Koito will be “infinite”, we used the following formula:

P = ((1+g)/(r-g))*E(D)

NB: please find enclosed all tables at the end of the presentation.

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KOITO case study

FIRST CASE – TOYOTA MAINTAINS ITS TIES WITH KOITO

• The price we find is only theoretical• Therefore, it doesn’t reflect the market anomalies

(following major buyouts, economic downturns or upturns) that might occur.

• Throughout all the case we presumed that Koito would have a constant infinite growth rate = g

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• Expected dividends per share: 10.485 in 1991 (based on the average growth of dividends from 1982 to 1990).

• ROE= 6.52%• g= 3.91%• WACC=r= 6.15%• Price obtained=

486.21 yen

KOITO case study

SECOND CASE – TOYOTA BREAKS ITS TIES WITH KOITO (NET INCOME DECREASES BY 53%)

Why 53%? • Exhibit 6 shows that Daihatsu Motor and Hino Motor

belongs to the Toyota Motor Group. Therefore, as Daihatsu and Hino represent 3% and 2% of Koito’s revenues, if Toyota decides to break all ties with Koito, it will be a loss of 53% of Koito’s revenues.

Sub case 1• Dividends are maintained even though net income

decreased by 48% since Toyota ceased to be a customer. • Expected dividends per share: 10.485 in 1991 (based on

the average growth of dividends from 1982 to 1990).• ROE= 3.06%• g= 0.63%• WACC=r= 3.12%• Price obtained= 423.3 yen

Sub case 2• Dividends are divided by 2 in 1991 (then growth as usual),

decision taken by the Management because net income dropped by 48%.

• Expected dividends in 1991: 5.• ROE= 3.06%• g= 1.90%• WACC=r= 3.12%• Price obtained= 418.9 yen

• In both subcases the price of the stock is significantly lower than the calculated theoretical stock price of Koito without Toyota breaking its ties. Even though Mr. Pickens might try to persuade Koito’s shareholders to join his side with higher dividends we see that they don’t play such a big role here.

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KOITO case study

THIRD CASE – TOYOTA BREAKS ITS TIES BUT KOITO COVERS 50% OF THE INCURRED LOSSES (OTHER CUSTOMER(S) FOUND)

• Expected dividends per share: 10.485 in 1991 (based on the average growth of dividends from 1982 to 1990).

• ROE= 4.79%• g= 2.35%• WACC=r= 4.63%• Price obtained=

470.5 yen

• As we see, if this situation occurs it would be more difficult for the current shareholders to decide whose side to choose

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KOITO case study

PRICES OBTAINED

• We see that in any case prices are lower if Toyota breaks its ties.

• If we regard only from a quantitative point of view, as a minority shareholder of Koito we concluded that we would take the position of Toyota if such a situation came up.

• However, it depends on the minority shareholder’s intent. If he plans to acquire more shares and/or wants to change the company’s policy (in order to have voting rights or other privileges) it would be better to take Mr. Pickens’ side and try to pierce the kereitsu.

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Normal

P= 486.2138

Price without Toyota

P= 423.3362

dividends remain

Price without Toyota

P= 418.8946

dividends = 5

Price with 73.5%

P= 470.4957294

KOITO case study

CONCLUSION FOR QUESTION 5

• A large shareholder that has good ideas has enough weight to implement them. That can have a great impact on the company. In addition, large shareholders can monitor the managers that abuse of their position.

• However, large shareholders do not seem to be an effective solution to the corporate governance problem. This is clear when we saw the kind of problems Pickens brought to Koito after acquiring a large amount of shares. Different issues can arise:

• Large shareholders may greenmail the company,• They may abuse of their position• Large shareholders that enter the board of directors often

monitor the managers. The main problem still remains: who monitors the monitors?

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KOITO case study

ANNEX QUESTION 5 - GROWTH RATE IF TOYOTA REMAINS AS A CUSTOMER

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1982 1983 1984 1985 1986 1987 1988 1989 1990Dividends/share 7 7 7 7.5 8 8 8 8 10Earnings/share 17.55 17.27 18.08 28.63 20.58 15.92 21.34 17.9 22.93Payout ratio 0.399 0.405 0.387 0.262 0.389 0.503 0.375 0.447 0.436Plowback ratios 60% 0.595 0.613 0.738 0.611 0.497 0.625 0.553 0.564Average plowback ratio 0.600 g= 3.91%

KOITO case study

ANNEX QUESTION 5 – CALCULATION OF GROWTH RATE IF TOYOTA LEAVES

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1990 1991 1992 1993 1994 1995Dividends/share 10 10.49 10.99 11.53 12.09 12.67Earnings/share 22.93 11.92 13.16 14.52 16.03 17.69Payout ratio 0.436 0.880 0.84 0.79 0.75 0.72Plowback ratios 0.564 0.120 0.164 0.206 0.246 0.284 Average plowback ratio 0.204

g wihout Toyota first case g= 0.63% 1990 1991 1992 1993 1994 1995Dividends/share 10 5 5.24 5.50 5.76 6.04Earnings/share 22.93 11.922 13.16 14.52 16.03 17.69Payout ratio 0.436 0.419 0.40 0.38 0.36 0.34Plowback ratios 0.564 0.581 0.602 0.622 0.640 0.658 Average plowback ratio 0.621

g wihout Toyota 2nd case g= 1.90% 1990 1991 1992 1993 1994 1995Dividends/share 10 10.49 10.99 11.53 12.09 12.67Earnings/share 22.93 18.64 20.58 22.71 25.07 27.67Payout ratio 0.436 0.56 0.53 0.51 0.48 0.46Plowback ratios 0.564 0.438 0.466 0.492 0.518 0.542 Average plowback ratio 0.491

g with 76% g= 2.35%

KOITO case study

ANNEX QUESTION 5 - ROE

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If Toyota remains If Toyota remains 1982 2 362 Date Prevision of stockholders' equity Prevision of net income ROE1983 2 324 -38 -1.61% 1990 56 760 3 677 6.48%1984 2 434 110 4.73% 1991 62 482 4 058 6.50%1985 4 133 1699 69.80% 1992 68 782 4 479 6.51%1986 2 968 -1165 -28.19% 1993 75 716 4 944 6.53%1987 2 296 -672 -22.64% 1994 83 350 5 457 6.55%1988 3 415 1119 48.74% 1995 91 753 6 023 6.56%1989 2 871 -544 -15.93% Average ROE 6.52%1990 3 677 806 28.07%

Annual growth in net income 10.37%

Without Toyota Without Toyota1982 1 110 Date Prevision of stockholders' equity Prevision of net income ROE1983 1 092 -17.86 -1.61% 1990 56 760 1 728 3.04%1984 1 144 51.7 4.73% 1991 62 482 1 907 3.05%1985 1 943 798.53 69.80% 1992 68 782 2 105 3.06%1986 1 395 -547.55 -28.19% 1993 75 716 2 324 3.07%1987 1 079 -315.84 -22.64% 1994 83 350 2 565 3.08%1988 1 605 525.93 48.74% 1995 91 753 2 831 3.09%1989 1 349 -255.68 -15.93% Average ROE 3.06%1990 1 728 378.82 28.07%


With 73.5% of initial earnings With 73.5% of initial earnings1982 1 736.07 Date Prevision of stockholders' equity Prevision of net income ROE1983 1 708.14 -27.93 -1.61% 1990 56 760 2 703 4.76%1984 1 788.99 80.85 4.73% 1991 62 482 2 983 4.77%1985 3 037.76 1248.765 69.80% 1992 68 782 3 292 4.79%1986 2 181.48 -856.275 -28.19% 1993 75 716 3 634 4.80%1987 1 687.56 -493.92 -22.64% 1994 83 350 4 011 4.81%1988 2 510.03 822.465 48.74% 1995 91 753 4 427 4.82%1989 2 110.19 -399.84 -15.93% Average ROE 4.79%1990 2 702.60 592.41 28.07%


KOITO case study

ANNEX QUESTION 5 - WACC CALCULATION (1/2)

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Toyota leaves – calculation of WACCToyota remains – calculation of WACC

Equity Debt Total D/(E+D) E/(E+D)1982 27153 3211 30364 0.11 0.891983 28600 3345 31945 0.10 0.901984 30047 4210 34257 0.12 0.881985 37885 4684 42569 0.11 0.891986 39947 4369 44316 0.10 0.901987 41023 14698 55721 0.26 0.741988 52733 5555 58288 0.10 0.901989 54434 6019 60453 0.10 0.901990 56760 6296 63056 0.10 0.90

Average 12.2% 87.8%Assumption: same for next periods (due to a stability policy by the

company) WACC = r = 6.15%

Equity Debt Total D/(E+D) E/(E+D)1982 27153 3211 30364 0.11 0.891983 28600 3345 31945 0.10 0.901984 30047 4210 34257 0.12 0.881985 37885 4684 42569 0.11 0.891986 39947 4369 44316 0.10 0.901987 41023 14698 55721 0.26 0.741988 52733 5555 58288 0.10 0.901989 54434 6019 60453 0.10 0.901990 56760 6296 63056 0.10 0.90



KOITO case study

ANNEX QUESTION 5 - WACC CALCULATION (2/2)

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Toyota leaves but 26.5% of the losses covered.

With 73.5% Equity Debt Total D/(E+D) E/(E+D)

1982 27153 3211 30364 0.11 0.891983 28600 3345 31945 0.10 0.901984 30047 4210 34257 0.12 0.881985 37885 4684 42569 0.11 0.891986 39947 4369 44316 0.10 0.901987 41023 14698 55721 0.26 0.741988 52733 5555 58288 0.10 0.901989 54434 6019 60453 0.10 0.901990 56760 6296 63056 0.10 0.90



Bibliography used for the case study

References• The Japanese style of Business Accounting, Hidetoshi

Yamaji; • Financial statement fraud: prevention and detection,

Zabihollah Rezaee, Richard Riley;• “Agency Problems and dividends policies around the

world” (1999, la Porta, Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny)

Internet links• http://www.tradingeconomics.com/japan/government-

bond-yield => website used to find the risk free rate;

koito case

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