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
Porters 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: lets 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 Toyotas 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 4
th
of October).
2/ Therefore, this does not allow him to inspect Koitos
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: Koitos 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 Toyotas 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 Koitos
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
(Porters five forces). Japanese carmakers will not pay
higher prices for parts of cars. Therefore, losing an
important customer like Toyota (53% of Koitos 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 doesnt 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 Koitos
revenues, if Toyota decides to break all ties with Koito, it
will be a loss of 53% of Koitos 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 Koitos shareholders to join his side
with higher dividends we see that they dont 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 shareholders
intent. If he plans to acquire more shares and/or
wants to change the companys 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 1990
Dividends/share 7 7 7 7.5 8 8 8 8 10
Earnings/share 17.55 17.27 18.08 28.63 20.58 15.92 21.34 17.9 22.93
Payout ratio 0.399 0.405 0.387 0.262 0.389 0.503 0.375 0.447 0.436
Plowback ratios 60% 0.595 0.613 0.738 0.611 0.497 0.625 0.553 0.564
Average 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 1995
Dividends/share 10 10.49 10.99 11.53 12.09 12.67
Earnings/share 22.93 11.92 13.16 14.52 16.03 17.69
Payout ratio 0.436 0.880 0.84 0.79 0.75 0.72
Plowback 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 1995
Dividends/share 10 5 5.24 5.50 5.76 6.04
Earnings/share 22.93 11.922 13.16 14.52 16.03 17.69
Payout ratio 0.436 0.419 0.40 0.38 0.36 0.34
Plowback 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 1995
Dividends/share 10 10.49 10.99 11.53 12.09 12.67
Earnings/share 22.93 18.64 20.58 22.71 25.07 27.67
Payout ratio 0.436 0.56 0.53 0.51 0.48 0.46
Plowback 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 ROE
1983 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 Toyota
1982 1 110 Date Prevision of stockholders' equity Prevision of net income ROE
1983 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%
Annual growth in net income 10.37%

With 73.5% of initial earnings With 73.5% of initial earnings
1982 1 736.07 Date Prevision of stockholders' equity Prevision of net income ROE
1983 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%
Annual growth in net income 10.37%
KOITO case study
ANNEX QUESTION 5 - WACC CALCULATION (1/2)
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Toyota leaves calculation of WACC
Toyota remains calculation of WACC
Equity Debt Total D/(E+D) E/(E+D)
1982 27153 3211 30364 0.11 0.89
1983 28600 3345 31945 0.10 0.90
1984 30047 4210 34257 0.12 0.88
1985 37885 4684 42569 0.11 0.89
1986 39947 4369 44316 0.10 0.90
1987 41023 14698 55721 0.26 0.74
1988 52733 5555 58288 0.10 0.90
1989 54434 6019 60453 0.10 0.90
1990 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 0.89
1983 28600 3345 31945 0.10 0.90
1984 30047 4210 34257 0.12 0.88
1985 37885 4684 42569 0.11 0.89
1986 39947 4369 44316 0.10 0.90
1987 41023 14698 55721 0.26 0.74
1988 52733 5555 58288 0.10 0.90
1989 54434 6019 60453 0.10 0.90
1990 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 = 3.12%
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 0.89
1983 28600 3345 31945 0.10 0.90
1984 30047 4210 34257 0.12 0.88
1985 37885 4684 42569 0.11 0.89
1986 39947 4369 44316 0.10 0.90
1987 41023 14698 55721 0.26 0.74
1988 52733 5555 58288 0.10 0.90
1989 54434 6019 60453 0.10 0.90
1990 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 = 4.63%
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;