Module 11: Adjusting Enterprise Operations

1. Module 11: Adjusting Enterprise Operations Mairin Talerico

2. Snapshot of Toyota Limited liability, joint-stock company incorporated under Commercial Code of Japan; started in 1930s Primarily in automotive industry, but also financial services and others Sold 9.98 million vehicles in fiscal 2013 Sell in 170 different countries and regions Primary markets: Japan, North America, Europe and Asia

3. Auto Manufacturing – At a Glance TM F GM

4. SWOT Analysis Strengths Opportunities Research and Development initiatives A leader in green cars development Selling in Japan and North American markets Geographically expansive manufacturing locations Toyota Motor Credit Credit Corporation [49% US Sales had financing] Develop environmentally friendly vehicles and technologies Safe vehicles Ability to increase market share in growing economies and markets Sustainable growth and optimal supply of products globally Finance more cars and increase profits Growth through acquisitions

5. SWOT Analysis Cont. Weaknesses Threats Product recalls Always staying abreast of new technology and financial offerings Abiding by all gov’t regulations and legal proceedings Declining sales in Europe 51% US Sales don’t have financing Weak presence in emerging markets Brand reputation Worldwide auto market is highly competitive, volatile + Financial services industry Decrease profit Risk losing a major market for sales Highly competitive financial services industry

6. Adjustment A: Inventory Method Toyota uses LIFO Method Note 2: Summary of Significant Accounting Policies 2013 Inventories - Inventories are valued at cost, not in excess of market, cost being determined on the “average-cost” basis, except for the cost of finished products carried by certain subsidiary companies which is determined on the “specific identification” basis or “last-in, first-out” (“LIFO”) basis. Inventories valued on the LIFO basis totaled ¥220,582 million and ¥220,082 million ($2,340 million) at March 31, 2012 and 2013, respectively. Had the “first-in, first-out” basis been used for those companies using the LIFO basis, inventories would have been ¥56,799 million and ¥66,979 million ($712 million) higher than reported at March 31, 2012 and 2013, respectively. Note 2: Summary of Significant Accounting Policies 2012 Inventories – […] Inventories valued on the LIFO basis totaled ¥151,183 million and ¥220,582 million ($2,684 million) at March 31, 2011 and 2012, respectively. Had the “first-in, first-out” basis been used for those companies using the LIFO basis, inventories would have been ¥57,943 million and ¥56,799 million ($691 million) higher than reported at March 31, 2011 and 2012, respectively.

7. Adjustment A: Inventory Method Add LIFO reserve of $712m to LIFO inventory. This $712m increase to 2013 inventories would have increased its cumulative pretax by $712 and taxes by $263m (712*.37). Thus, to adjust 2013 B/S, increase inventory by $712, tax liabilities by $263m (extra taxes TM would have to pay under FIFO), and equity by the difference of $449m. Therefore, NEA increases by net amount of $449m to $173,532m

8. Adjustment A: Inventory Method TM’s EPAT for 2013 was $13,618. To adjust to as if FIFO, use the change in LIFO reserve, increase of $21m from 691m in 2012 to 712m in 2013. Had TM used FIFO, its COGS would have been $21m lower, and its 2013 gross profit and pretax income would have been $21m higher. In 2013, TM would have paid $7.77m more in taxes (21m*.37). Therefore, EPAT for TM would increase by the net amount of 13.23m to $13,631m.

9. Adjustment A: Inventory Method Journal Entries 435=(712-263)-(21-8) Subtract the difference b/c it was a decrease to COGS

10. Adjustment B: Operating Leases • The capitalization process: • Determine the discount rate. • Compute the present value of future lease payments. • Adjust the balance sheet to include the present value from step 2 as both a lease asset and a lease liability. • Adjust the income statement to include depreciation and interest in lieu of rent expense.

11. Adjustment B: Operating Leases Step 1: Using IRR function in excel, compute an IRR that equates future payments to the disclosed present value of those payments, using Note 22: Lease commitments.

12. Adjustment B: Operating Leases Step 2: Compute present value of future operating lease payments using the discount rate of 6%. The omitted asset and liability related to operating leases is $516.28 million as of the end of 2013.

13. Adjustment B: Operating Leases Step 3: Adjust the Balance Sheet to include the PV from step 2 as both a lease asset and a lease liability

14. Adjustment B: Operating Leases Step 4: Adjust the income statement to include depreciation and interest in lieu of rent expense. Capitalizing operating leases affects EPAT via the addition of depreciation related to the lease equipment as well as the removal of the operating lease payments which has been reported as rent expense (in SGA) TM discloses in Note 22 that its rental expense under operating leases totaled $958 million for 2013. Remove rental expense from SGA, and reclassify it as $31.27m of interest expense, and 926.73m as depreciation expense. Using TM’s effective tax rate of 39.3% in Note 16, the net increase to EPAT is $18.98m.

15. Adjustment B: Operating Leases

16. Adjustment C: Special-Purpose Entities SPEs allow companies to structure projects or transactions with a number of financial advantages, and are consolidated in the sponsoring company’s FS NEA and EPAT are unaffected Two analysis implications: cost of debt capital and liquidity Variable Interest Entities - Toyota enters into securitization transactions using special-purpose entities, that are considered variable interest entities (“VIEs”). Although the finance receivables and vehicles on operating leases related to  securitization transactions have been legally sold to the VIEs, Toyota has both the power to direct the activities of the VIEs that most significantly impact the VIEs’ economic performance and the obligation to absorb losses of the VIEs or the right to receive benefits from the VIEs that could potentially be significant to the VIEs. As a result, Toyota is considered the primary beneficiary of the VIEs and therefore consolidates the VIEs. The consolidated securitization VIEs have $12,074 million in retail finance receivables, $443 million in vehicles on operating leases, $625 million in restricted cash and $10,400 million in secured debt as of March 31, 2013. Risks to which Toyota is exposed including credit, interest rate, and/or prepayment risks are not incremental compared with the situation before Toyota enters into securitization transactions.

17. Adjustment D: Share-Based Compensation

18. Adjustment D: Share-Based Compensation • Step 1: Compute value of options exercisable at beginning of year using beginning of year share price • $86.82 according to Yahoo finance • This is $29.45 greater than the exercise price of $57.37 for the 9,778,000 exercisable options • Beginning ESO overhang = $287,925,556 As of March 31, 2013, the employee stock ownership association held 17,130,363 (of 3.4b) shares of Toyota’s common stock.

19. Adjustment D: Share-Based Compensation • Step 2: Compute the value of options exercisable at beginning of year using end of year share price • $102.64 according to Yahoo Finance • This is $45.27 greater than the exercise price of $57.37 for the 9,778,000 exercisable options • Value of options exercisable at beg of yr = $442,613,516

20. Adjustment D: Share-Based Compensation • Step 3: Estimate the value of ESOs exercised during the current year using the average share price • Average share price = 94.73 • This is $59.34 greater than the average exercise price of $35.39 for the 645,000 exercised options during the year • Value of ESOs exercised in CY = $38,277,246

21. Adjustment D: Share-Based Compensation • Step 4: Estimate the value of ESOs cancelled during the current year using the average share price • Average share price = 94.73 • This is $31.92 greater than the average exercise price of $62.81 for the 1,036,000 cancelled options • Value of cancelled ESOs = $33,072,210

22. Adjustment D: Share-Based Compensation • Step 5: Compute value of options exercisable at end of year using end of year share price • Ending share price= $102.64 • This is $50.44 greater than the exercise price of $52.20 for the 10,849,000 exercisable options • Ending ESO overhang = $547,270,855

23. Adjustment D: Share-Based Compensation • Step 6: Compute estimate of additional share-based compensation from information computed above. • This computation of additional compensation using the results is: • (5) – (2) +(3) + (4) = (6) • $547,270,855 - $442,613,516 + $38,277,246 + $33,072,210 • = $176,006,794

24. Adjustment D: Share-Based Compensation • Step 7: Adjust NFL, CSE, EPAT, and FEAT using information already computed. • Increase NFL by (5) $547,270,855 • Decrease CSE by (5) $547,270,855 • Decrease EPAT by (6) $176,006,794 • Increase FEAT by (2)-(1)-(3)-(4) $83,338,505 • Adjusting EPAT and NEA incorporates ESOs which are excluded under US GAAP. Including it creates more comparability among companies with varying degrees of ESOs.

25. Adjustment D: Share-Based Compensation The first entry is a prior period adjustment to record the beginning balance of share-based compensation liability (=beginning ESO overhang). The second adjusts the liability to the end of the year value by recognizing the current year effects on EPAT and FEAT.

26. Questions?