INTERNATIONAL FINANCIAL ECONOMICS UNIVERSITY OF AMSTERDAM

Koito Manufacturing, Ltd.

Jasper Dijkstra Jack Driessen Mark Jager Xin Wang Maarten Dalm

5876362 0516511 10192921

10216081

Question 1 Many economists argue that the keiretsu system has been a formidable impediment to the entry of Western companies into the Japanese market. However, the absence of liberal market competition may preclude Japanese firms from implementing more cost-effective sourcing strategies at the global standard. Furthermore, it is often argued that the keiretsu system has been partly responsible for the decade-long recession: while there was need for quick changes, the negative features of the keiretsu form of governance maintained the economic slump. The interdependence of suppliers, unproductive cost management and top-down decision making based upon continuity and consensus all contributed to the decade-long recession. We will now discuss the corporate governance issues that may arise, seen from different perspectives. a) From the perspective of financiers. Financiers are always looking for the best investment possibilities. The keiretsu system can make it difficult for (individual) financiers to invest in the best possible option. This is because of the fact that a keiretsu will not allow foreign or alien companies into their system. On the other hand, when the leading company of the keiretsu needs money, financiers can more or less be obliged to invest: the money is invested in a bad project and possible profits are lost (Kawai, 2009). b) From the perspective of owners. One of the key features of the keiretsu system is member cross-ownership. These owners are the control-oriented owners. Their primary concerns are the relationships with the businesses in which they have stocks. So their objective is to maximize the relationship values and the economic performance of their keiretsu as a whole, not maximizing the market value of a single company: these cross holding arrangements also lead to ambiguity on whose interests are really being represented. c) From the perspective of suppliers The major issue for suppliers is that they can be exploited by their Keiretsu leading company. Because of the tremendous dependence of the suppliers on their principals, they are basically forced to accept all terms and conditions. Also in our case, Koito is more or less dependent on Toyota group, which is responsible for 53% of the sales. d) From the perspective of employees. The employees work in the same keiretsu during their career. They can work in different companies during the time, but will not work for another keiretsu. Employees of different companies in one keiretsu will often engage in switches between companies for the long term or for a short-term joint project. For that dedication to the keiretsu the employees are rewarded with job-security, health insurance and other benefits.

Question 2 Mister T. Boone Pickens bought shares in Koito Manufacturing to invest. By being the largest shareholder of the company he would have thought that he could have much to say about the company. This is not the case in Japan. In America it is custom to put shareholders interest first, but in Japan there are other different kind of stakeholders that boards in Japan think about. As can be seen from the previous question, in Japan they also take financers, owners, suppliers, employees and also customers and local community into account. Although he was the largest shareholder, he was never in control of the company. The board of directors accuses him of being a greenmailer mainly to convince the other shareholders not to vote with him on the annual meetings and to resist giving him the company accounts. First of all, the Japanese law probably allows T. Boone Pickens on the board, but there are two reasons why he will never be on the board. Firstly, he will not get enough votes in an annual meeting to be voted on the board, because the current board of directors accuses him of being a greenmailer. Usually members of the board are elected with unanimous vote. Secondly, there is a large culture difference between the Japanese corporate governance and the Anglo-American corporate governance. In America the board consists of independent, outside directors, but in Japan almost all directors are from inside of the keiretsu. It is important to them that the big stakeholders within the keiretsu are represented on the board so everybody can ensure their own interest. This does not mean that major shareholders have board representation. The employees of these companies with large shares are almost always put forward to represent the large shareholders on the board. These employees do not have large shares in the company. Mr Pickens could, if a shareholder holds more than 10% of the shares, ask to inspect the companys accounting records and to apply to a court to appoint a special auditor for this purpose. The problem here is that the company is allowed to reject this if they believe the shareholder wants to harm the company. This request by T. Boone Pickens was denied twice probably for reasons above. Japanese law also allows large shareholders to make a proposal to the board of directors. After a six-month waiting period for exercising his shareholder rights, Mister T. Boone Pickens demanded that Koito Manufacturing should raise its dividends. The board must at least give a reaction in writing according to Japanese law. In the end he got a raise in dividends, but it was only as small part of what he asked for. As will be illustrated in the next question it is not surprising Mister T. Boone Pickens asked for a larger dividend pay-out. Question 3 Mister T. Boone Pickens demanded higher dividend pay outs. There are two ways to approach this problem. First, the historic percentage dividend and retained earnings to the net income is looked at. After that, the upper limit of dividend that is regulated by Japanese law is considered. Both give different insights to the problem.

If we look at the figures of net income and the amount that is paid out as a dividend, the percentage is quite constant. The average ratio is 40% and this is lower than the dividend ratio received in 1989 and 1990, 45% and 44% respectively (figure 1). Thus, looking at the history of the dividends it is not so surprising that Koito Manufacturing did not raise the dividends. On the other hand, the amount of retained earnings is very high. On average 58% of the net income is reserved as retained earnings and therefore not paid out as dividends. This is a vast amount of earnings that is not distributed to shareholders. In the commercial code of Japan there are two articles that provide a legal upper limit to the total amount of dividends. Article 290 (Profit dividends) and article 293-5 (Midterm dividends). Here the total amount of dividends that can be paid out is the net assets less total capital and reserves, less legal earned surplus and less dividend and acquisition costs. For midterm dividends, article 293-5, this amount gets corrected with the reduction of past years legal earnings surplus and capital. This has not happened in the years given in the case. It can be seen from figure 2 that the maximum amount of dividends is not paid out. Taken into account these figures, the maximum dividends are much higher than the dividends actually paid by Koito Manufacturing. The difference between this is even rising through the years, see figure 2. In 1990 the total difference is almost 20.000 million Yen and thus it is not surprising that Mister T. Boone Pickens demands higher dividends. As can be seen from the balance sheet in the case (Exhibit 4), voluntary earned surplus and unappropriated are the accounts where the earnings that have been retained are held. As can be seen these accounts are increasing every year. There is one way in which Mister T. Boone Pickens can try to get more dividends. He can try to make the directors liable for distributing a smaller amount than the differential of the dividends based on article 293-5, paragraph 5 of the commercial code of Japan. Only when the directors can prove that this is done because of care in his view, than this is not considered as a liability for the directors. On the basis of article 266 (liability of directors of the corporation) of the commercial code of Japan, the directors are liable if a shareholder submitted a proposal relating to profit dividends. Mister T. Boone Pickens has done this, but it does not mean the Directors have to obey him if they are careful. Mister T. Boone Pickens would have a strong case looking at the figures, because the difference in paid and maximum dividends is rising. He can make the directors liable for not distributing enough dividends. Mister T. Boone Pickens did not do this, because this could be interpreted as greenmailing. He does not want to get this reputation because this would mean the directors of Koito will not take him seriously. Furthermore, if the directors suspect him of greenmailing, they have another reason to refuse him the demand of inspection of accounts based on article 293-7 of the commercial code of Japan. In this article the directors can refuse the inspection of accounts if they think the inspector is a treat to the company. This is the case at the moment, and in this way the directors can try to keep him in the dark.

Question 4 Toyota and Koito are in a vertical Keiretsu (exhibit 6). This implies that these two corporations engage in a tight and long-term commercial relationship. Toyota is the main company of the Keiretsu, it is the most important customer of Koito with 48% of the sales (exhibit 2) and it is the second largest shareholder of Koito with 19% (exhibit 1). Therefore Toyota has a lot of influence on Koito and a negative effect on the profits of Toyota would affect Koito negatively as well. So if Koito would increase their prices for Toyota it could be harmful for Koito and for Toyota. Since Toyota has power over Koito, it could keep the prices artificially low at the expense of shareholders. A self-dealing transaction occurs when there is a company or a director on both sides of the transactions. Three members of the board of Koito were, according to Pickens, representatives of Toyota. So Toyota was on both sides of the transactions and thus it is a self-dealing transaction. Pickens could look at the prices that are set for Toyota and for other companies. If, for the same product, the prices for Toyota differ from prices for other companies, it could be proven that Toyota limited the profits of Koito. This is then also proves that there occurred a selfdealing transaction between Toyota and Koito. If we were investment bankers we would tell Pickens to investigate the dividend yield, because it dropped from 2.32% in 1982 to 0.34% in 1990, and it was even lower, 0.16%, in 1989 (exhibit 5). This can be proof that Koito pays too little dividend. Also there could be proof of overvaluation of the shares of Koito. This can be seen in exhibit 5 as well. The P/E ratio is very high in 1989 compared with the years before. This can be explained by overvaluation of the shares. As the P/E ratio is, market value per share divided by the earnings per share, the high stock price in 1989 is the cause of the high P/E ratio. Thus the EPS are not growing as hard as the stock price, which can indicate that the stock price is too high. Other things Pickens could investigate are explained in questions 3, the amount of dividends paid. We would change the charter of the organization. First, the representatives of Toyota should be removed from the board and there should not be other retirees from Toyota on the board of Koito to prevent self-dealing transactions. Second, there should be independent directors on the board of Koito. They can have an unbiased look at the profits of the company and they could look after the interest of minority shareholders who are not on the board. Question 5 The Toyota Motor Group consists of many companies built around the car building company Toyota Motor. Other car manufacturers belonging to the group are Daihatsu Motor and Hino Motors (exhibit 6). In total these companies comprise a share in Koito Manufacturing Ltd of 53% of customer base (exhibit 2). If T Boone Pickens would take over the company, Toyota Group would cut all ties resulting in a tremendous loss in sales. Since Toyota Motor group is responsible for more than half of Koitos sales, a retreat of the company would be devastating for the current stockholders of Koito Manufacturing.

Being a minority shareholder, and having to choose between Koito Ltd and T. Boone Pickens, we would definitely choose the side of Koito Ltd. Our main argument is that when T. Boone Pickens would take control of the company, Toyota Motor Group would cut all ties with Koito Ltd, resulting in a huge loss in sales and consequently shareholder value. As mentioned before, 53% of the total sales of Koito Manufacturing Ltd. are to companies belonging to the Toyota Motor Group. In a situation where T. Boone Pickens takes full control of the company and the Toyota Motor Group decides to cut all ties, it is reasonable to assume that the companies of the Toyota Motor Group will no longer buy auto parts from Koito Manufacturing. This is because the Japanese keiretsu system exists of first and seconddegree suppliers, where Koito Manufacturing can be appointed to the first-degree suppliers being in direct contact with the car assemblers. Koito in its turn buys its intermediate goods from the second-degree suppliers also belonging to the Toyota Motor Group. They will probably also need to search for new suppliers for these intermediate goods as these ties will probably be cut as well. A very important note is that we assume that the share price at 1990 fully reflects the beliefs of the stockholders of Koito Manufacturing which means that Toyota Motor remains a client of Koito Manufacturing. Although the latter case is hard to quantify we can, however, take the loss in customer base into account. If T Boone Pickens takes control of the company in 1990, we argue that 53% of the revenue will be gone. The annual growth rate of the sales of the company is about 7.2% per year (see table 1). We have further assumed that the large accounts in the income statement will remain the same as a percentage of sales (e.g. costs of goods sold were around 85% of sales in the last 8 years; see table). In table 3 our prognosis for the coming 10 years is stated. In 1991 the company will lose 53% of its existing customer base. We have however assumed an autonomous growth rate of 7.2%, which was also the case in period before the take-over. This results in total sales of 62,256 million over 1991. The other accounts have been calculated as a percentage of sales (the percentages are calculated in table 2). For the following nine years the autonomous growth rate of 7.2% is furthermore assumed for sales. The same goes for the balance sheet items (see table 4). Now that we have calculated all the financial statement items for the period after a possible takeover of T. Boone Pickens, the free cash flows have to be calculated before we can calculate the share price. This is done in table 5. Free cash flow = EBIT taxes+ depreciation change in net working capital capital expenditures. The discounted free cash flows are also stated in table 5. The valuation of the share price is according to figure 3 where we also take into account the cash reserves and interest bearing debt of the company. The fair value of the share then becomes 341, which is only a fraction of the share price at 1990 of 2,950 (exhibit 5).

Appendix
Figure 1

Figure 2

Figure 3: DCF Valuation

Source: http://www.valuatum.com/supportportal/support/help-files-by-topic/wacc-&-valuation/112-dcfvaluation.html

DCF Valuation Cumulative discounted FcF (millions) Interest bearing debt (millions) Cash at bank (millions) Value of equity, DCF (millions) Number of shares total (millions) Fair value of share, DCF 341 160.36 18,540 54,611 261 36,332

Table 1: annual growth per year

1982-1983 sales 2.9%

1983-1984 7.3%

1984-1985 7.9%

1985-1986 10.2%

1986-1987 4.1%

1987-1988 9.4%

1988-1989 5.1%

1989-1990 10.9%

average 7.2%

Table 2: as a % of sales

1982 COGS SG&A expenses Operating income Non-operating income Non-operating expenses Current Assets Fixed Assets Total assets Current liabilities Total Liabilities Stockholder's equity 41.5% 29.8% 71.3% 28.2% 33.0% 38.3% 85.2% 9.4% 2.2% 0.6% 0.4%

1983 85.3% 9.8% 2.4% 0.5% 0.4%

1984 83.5% 10.9% 2.3% 0.5% 0.2%

1985 83.6% 10.6% 2.7% 0.6% 0.2%

1986 84.1% 10.6% 2.7% 0.4% 0.2%

1987 85.6% 10.7% 2.7% 0.7% 0.1%

1988 83.9% 11.2% 2.3% 0.3% 0.2%

1989 85.2% 10.9% 2.5% 0.3% 0.1%

1990 86.2% 10.6% 2.5% 0.5% 0.1%

average 84.7% 10.5% 2.5% 0.5% 0.2%

41.5% 29.5% 71.0% 27.2% 31.8% 39.2%

44.1% 27.4% 71.5% 27.7% 33.1% 38.4%

49.3% 28.0% 77.3% 26.9% 32.4% 44.8%

45.5% 28.0% 73.4% 25.9% 30.5% 42.9%

53.1% 28.7% 81.8% 24.6% 39.7% 42.1%

57.0% 24.7% 81.7% 26.8% 32.0% 49.7%

48.9% 29.5% 78.4% 24.2% 29.6% 48.8%

49.7% 28.8% 78.5% 27.5% 32.6% 45.9%

47.8% 28.3% 76.1% 26.5% 32.8% 43.3%

Table 3: prognoses when T Boone Pickens takes over the company income statement

1991 sales COGS Gross profit SG&A expenses Operating income Non-operating income Non-operating expenses 127 Recurring profit income before taxes Taxes net income 4,177 4,177 2,229 1,948 62,256 52,753 9,503 6,555 2,947 1,535 305

1992 66,749 56,561 10,188 7,028 3,160 1,646 327

1993 71,567 60,643 10,924 7,536 3,388 1,764 351

1994 76,732 65,020 11,712 8,079 3,633 1,892 376

1995 82,270 69,712 12,558 8,663 3,895 2,028 403

1996 88,208 74,744 13,464 9,288 4,176 2,175 433

1997 94,574 80,138 14,436 9,958 4,477 2,332 464

1998 101,400 85,922 15,477 10,677 4,801 2,500 497

1999 108,718 92,124 16,595 11,447 5,147 2,680 533

2000 116,565 98,772 17,792 12,274 5,519 2,874 572

136 4,478 4,478 2,389 2,089

146 4,802 4,802 2,562 2,240

157 5,148 5,148 2,747 2,401

168 5,520 5,520 2,945 2,575

180 5,918 5,918 3,157 2,761

193 6,345 6,345 3,385 2,960

207 6,803 6,803 3,630 3,174

222 7,294 7,294 3,892 3,403

238 7,821 7,821 4,173 3,648

Table 4: prognoses when T Boone Pickens takes over the company - balance sheet

1991 Current Assets Fixed Assets Total assets Current liabilities Total Liabilities Stockholder's equity Capital expenditures change in net working capital
Table 5: Free cash flows

1992 31,935 18,867 50,802 17,721 21,867 11,215 1,948 957

1993 34,240 20,229 54,469 18,999 23,445 12,024 2,088 1,026

1994 36,711 21,689 58,400 20,371 25,137 12,892 2,239 1,100

1995 39,361 23,254 62,615 21,841 26,952 13,823 2,401 1,179

1996 42,202 24,933 67,134 23,417 28,897 14,820 2,574 1,264

1997 45,248 26,732 71,980 25,107 30,983 15,890 2,760 1,356

1998 48,513 28,661 77,175 26,919 33,219 17,037 2,959 1,454

1999 52,015 30,730 82,745 28,862 35,616 18,266 3,172 1,559

2000 55,769 32,948 88,717 30,945 38,187 19,585 3,401 1,671

29,786 17,597 47,383 16,528 20,395 10,460 -29,772 -13,036

1991 Free cash flows t Discount factor 44,935 1 0.12 1.12 Discount FcF 40,120

1992 -625 2 0.12 1.2544 -498

1993 -670 3 0.12 1.404928 -477

1994 -718 4 0.12

1995 -770 5 0.12

1996 -826 6 0.12

1997 -885 7 0.12

1998 -949 8 0.12

1999 -1,018 9 0.12

2000 -1,091 10 0.12

1.57351936 1.762341683 1.973822685 2.210681407 2.475963176 2.773078757 3.105848208 -456 -437 -418 -400 -383 -367 -351

References

Kawai N. Keiretsu Corporate Networks are Innate to the Japanese auto-sector, but could this System finally be changing? Japan inc, 2009.