Impact of Capital Structure on Financial Performance of Real Estate Firms - Literature review Example

Impact of capital structure on financial performance of real e firms listed in Chinese stock exchange Chinese Listed Real Estate Firms Over the past years, state owned enterprises dominated the Chinese industrial sector until the late 1980s when the government intervened and conducted an overhaul of the system. The government decided to take this bold step in order to end the black market trading that existed among the State owned enterprises. SOEs sold their shares to their own employees. They also merged to form joint stock companies in a similar manner and the overall effect was low liquidity of stocks, restricted stock trading and incurring of huge losses by the SOEs. Consequently, the government mandated a Beijing based department with the role of issuing shares in 1984. In early 1990s, the Chinese state council took the initiative of developing two national stock exchanges. According to CSRC (2008, p.3), the two fundamental national stock exchanges included Shenzhen Stock Exchange (SZSE) in 1991 and in 1990, the Shanghai Stock Exchange (SHSE). Development of the two significant national stock exchanges as aforementioned led to establishment of many listed companies, increased total market capitalization and trading volume. It is through these reforms that the department of housing and real estate in the ministry of construction introduced a new structure of private ownership of property. Li, Luo and Ao (2011, p. 294) demonstrates how the private ownership structure in the real estate industry has developed over the years to become the pivotal industry of the national economy. A study carried out with the intention of determining the relationship between real estate investment and the GDP growth in China showed that there is a stable long run relationship between the two. However, the empirical study further stated that the potential threshold effect of real estate investment on its contribution to GDP growth depends on per capita GDP thus different regions sampled for the study in China gave different impact. The contribution is high when per capita GDP is greater than $1000 while the converse is true. Real estate business is considered a major contributor to economic growth because the industry has large multiplier effects and is believed to be associated with many external social and social economic benefits. According to Country Intelligence report, 2014, p. 14 the real estate industry affects the economic development through its impact on employment, labor productivity, savings and total investment. Capital structure affects the market value of the firm, the cost of capital, the integral operative performance and the corporate governance of the firms. Analysts have the ability to use different ratios to evaluate the financial strength of a company’s capital structure. According to Dai (2011, p. 5), the capitalization ratio is used by analysts to analyze and determine the capital position of the company. Investment capital used by firms can remain raised in a number of ways. Foremost, ways of raising this investment capital includes seasoned offerings of common stock, preferred stock that comes under equity and initial public offerings. Other fundamental ways used include raised debts, bank loan, outer investment, earnest money and advance receipts. Choice of the means to raise these investment funds is dependent on relative cost of funds, the firm’s capital structure and the market value of the firm’s security. Consequently, researchers have developed several imperative theories for adoption with the intention of explaining the choice of securities taken by a firm. In the recent past, the China’s real estate firms have raised funds from the capital market by issuing stocks (China Real Estate Report, 2014, p. 41). Subsequently, they have developed a system of listed public companies controlled by small group of investors especially the state owned enterprises. Chang study (2010, p. 368) analyzes the problems associated with optimization of the capital structure of listed real estate companies and the influence of the capital structure on the financial performance of these real estate firms. Capital Structure Theories Researchers have developed Western theories and models to aid in the understanding of modern finance concepts on capital structure. These theories include Modigiani and Miller (MM), trading off theory (TOM) and the pecking order theory (POT). The dissertation discusses each theory extensively. One of the most classical modern theories is the Modigiani and Miller theory. According to this theory, the value of the enterprise is irrelevant with the firm’s capital structure in a perfect market situation. It assumes only two types of finance exists in such situations that is risky equity and risk free debt. People can lend and borrow at the risk free rates and thus no bankruptcy costs exist. Modigiani and Miller theory applies to all the firms in the same level of risk, with no agency costs, no growth and the information is symmetrical (Allen and Qian, 2012, p. 102). Trade off theory, implemented by Scott (2006, p. 27), demonstrates that an increase in the ratio of bonds is followed by an increase in the risk of the company too. Consequently, the company’s bankruptcies increase whereas the value of the company decreases. As a result, optimum capital structure of a firm describes an equilibrium point that arises because of financial crises cost and bankruptcy cost. The above-mentioned two costs attributes to a rise in the debt capital ratio and the section tax benefit. Myers and Majluf established the Pecking order theory. Myers and Majluf theory aimed at determining the influence of information sources on the financial behaviors and corporation investment between the insiders and the outside investors according Roshaiza and Azura (2014, p. 112). Myers and Majluf theory remains considered as a competitor to the Trade off theory. The theory gives an illustration of how retained earnings in a company remains affected because of internal funds dominating the corporate financing preference followed by debt financing and lastly equity financing in the event that adverse selection has to be made. Firms prefer taking debt to equity funds whenever there is need for external sources of funds. Such considerations remain a possibility because debt has considerably lower informational cost as compared to equity. In addition, Li study (2010, p. 26), takes into consideration the transaction costs that exist and their asymmetric information. Managers have an upper hand in obtaining relevant asymmetric information as compared to outside investors. Therefore, they have an advantage in that they can obtain issue bonds easily and thus the adverse signaling information due to issuing of equity is explicitly avoidable. Baker and Wurgler also developed a theory of capital structure as explained by Lu and Xin (2010, p. 35). Baker and Wurgler referred to the theory as market timing theory of capital structure. Market timing theory suggests that firms can time their equity issues by buying back their own shares whenever there is an under evaluation. Furthermore, the firms can also issue new stock whenever the stock prices considerably remain overvalued. The firm’s capital structure is considered to be because of cumulative outcome of the past attempts to time the equity market since the changes in leverage are related to their different timing measures in the market. Aims and Objectives of the Dissertation There exist two fundamental characteristics of the Chinese real estate firms. Foremost, economists believe that China is under transition from a command economy to a market economy. Secondly, there exists believe that most of the listed companies in Chinese stock exchange have been under ownership by the state organizations. Thus, the state still maintains its controlling right even after the firms go public. However, the real estate industry is undeterred and its rate of growth in China is overwhelming in relation to development speed and capital flow. The inherent dissertation will analyze the following objectives to give satisfactory information. 1. A critical analysis of the capital structure adopted by 20 firms listed on the Chinese stock exchange. Analysis of capital structure in this dissertation would be imperative in the inherent financial operation characteristics including low leverage, ownership structure, and long-term debt ratio among others. 2. A critical determination of the relationship that exists between capital structure and different variables of firms listed on the Chinese stock exchange. Understanding the inherent relationship between the two factors would be authoritative in exploring the impact of capital structure of the aforementioned firms. 3. A critical investigation on the factors that influence capital structure of the firms listed on the Chinese stock exchange. Though capital structure directly affects listed firms, it is domineering to explore related effects including those affecting capital structure itself. The study elaborates the outlined objectives as below; Critical analysis of capital Structure adopted by listed firms in China Different researchers have remained actively involved in the analysis of the capital structure of the listed real estate companies in the Chinese stock exchange. Consequently, the researchers have established various findings related to the capital structure. According to Wang (2012), the Chinese listed real estate firms characterizes long-term debt ratios, low leverage levels, unique mixed ownership structure and higher equity over fixed asset ratio (Huang and Boateng, 2013, p. 848). These characteristics results from the undeveloped nature of their corporate bonds and ownership structure. Li, Luo and Ao (2011, p. 293) suggests that the real estate companies have state owned stock with high liability. Moreover, most of the variables in the companies characteristics does not necessarily relate to capital structure thus causing short-term debt ratios hence negative relations. Research Methodology involved Research methods used for empirical study of the capital structure of real estate firms involves econometrics model with cycles of descriptive statistical analysis and quantitative methods (Julan, Leung, & Chu, 2014, p. 307). The methods and analyses are obtainable from the financial and accounting databases. This dissertation used a new database referred to as the China stock market and accounting research database (CSMAR) developed by the CSRC (2008, p. 19). Researchers have used CSMAR for a long time and it contains accounting data for over 1000 listed Chinese companies. The joint efforts of China accounting and finance research centers assisted in developing the database in the year 2000. Dai (2011, p. 3) have identified two major correlations. First, the correlation that exists between characteristics and leverage of the Chinese state controlled firms is similar to that of other countries. Therefore these companies are considered to be profit maximizes and major economic forces in the Chinese economy. This correlation implies that it is desirable to get SOEs listed in the stock exchange despite the fact that the controlling right remains with the state. The second correlation according to Dai (2011, p. 4) shows that Chinese listed companies in the Chinese stock exchange have lower leverage compared to other companies. The most probable reason for this correlation is the small bond market of china and its undeveloped nature. Moreover, there exists high Tobin’s Q thus making bond issuance and bank loans unappealing to the listed companies. Relationship between capital Structure and various variables of real estate firms Theoretical and empirical studies conducted on the capital structure of china listed real estate companies have shown that the major determinants include profitability and non-debt tax shields. Other determinants include volatility, growth opportunities, tax, size, and tangibility among others. According to Sheng-quan (2009, p. 20), the relationship that exists between these determinants and the capital structure of the companies can be determined. Bor-Yi, Cho-Min, and Chien-Ming (2011, p. 213) suggests that leverage increases with non-debt tax shields, fixed assets, firm size and investment opportunities. Whereas, the leverage decreases with advertising culture, profitability, volatility, the probability of bankruptcy and uniqueness of the product. Below is an in-depth explanation of each determinant. a) Profitability From the studies that have been carried out over the years, no consistent prediction has been made on the relationship between the profitability and leverage of the real estate firms. Theoretical studies such as tax-based models have shown that profitable firms should borrow more since they have an obligation of shielding their income from corporate tax. However, according to Allen and Qian (2012, p. 66), the pecking order theory recommends that firm should first use the retained earnings as investment funds. The firms should use bonds and new equity only when it is necessary. Companies with free cash flow and high profitability, having heavy debts can restrain the discretion in the management of the firm. Therefore, to have optimal contract between the outside investors and the corporate insiders, the company should have low debts. Empirical studies give contrasting findings from theoretical studies about profitability of Chinese listed real estate firms. Empirical studies suggest that profitability is negatively related to leverage in Chinese companies. In this dissertation, profitability is determined by the earnings before interest and tax (EBIT) scaled by total assets. b) Tangibility A theoretical study on the relationship existing between tangibility and capital structure of Chinese listed firms shows that tangibility is positively related to leverage. Essentially, through agency cost ownership and capital structure relationships can explain the results. Agency cost of debt is evident when a company decides to shift to a riskier investment after issuance of debt. The wealth has to remain transferrable to shareholders from creditors to exploit the equity nature. These assets can find use as collateral whenever the tangible assets of the firm are high hence reducing the probability of the lender having to suffer agency costs of debt. Therefore, a high level of tangible asset increases the firms leverage. In this dissertation, the tangibility is measured scaling fixed assets to total assets in the firm. c) Tax Taxes are imperative determinants of the capital structure in Chinese listed companies. Both tax loss carry forwards and investment tax credit affect the debt-equity choice condition about going public. The desirability of the debt financing at the margin is a positive variant when it comes to the marginal tax rate. Firms that characterized by high effective margin rates are encouraged to use more debt in to attain tax shield gain. In this paper, average tax rate has been used to measure the effect of tax on the leverage of the firms. d) Size According to results conducted by many theoretical and empirical studies conducted including Li study (2010, p. 26), leverage is positively affected by the size of the firm. Large firms opt to take long-term debts whereas small firms prefer short-term debts. Large companies have benefits over small organizations in that their bargaining power over creditors is increased. Consequently, they can take advantage over economies of scale. In addition, issuing debt and equity by the Chinese listed firms negatively relates to the size of the firm. The size of the firm further affects the information that outside investors obtain. Large firms often provide more information to lenders compared to small firms. As a result, large firms that have fewer problems due to asymmetric information tend to acquire more equity than debt hence their low leverage. In this paper, the study measures size of the Chinese listed firms by determining the natural logarithm of sales for each firm. Total assets can also be used to know the effect of size on leverage since it is correlated to the sales. e) Growth opportunities According to Chang (2010, p. 367), growth opportunities are negatively related to leverage. For firms with strong investment opportunities, pursuing of growth objectives may at times cause overlapping of shareholders and managements interests. However, amongst firms with limited investment opportunities, the agency costs of managerial discretion tend to decrease due to the presence of debts. Moreover, firms with high growth opportunity negatively affect the leverage of the firm. Empirical studies are also in agreement with leverage being negatively affected by growth opportunities. Tobin’s Q and sales growth rate is imperative in determining the effect of growth opportunities on the leverage of the Chinese listed firms since they give a better proxy of the future growth opportunities. f) Volatility Volatility negatively affects the leverage of a company. Volatility or business risk is a proxy for the profitability of financial distress. This is because, as the variance off the value of the assets of a firm increases, the systematic risk of equity decreases (Dai, 2011, p.5). Measures of volatility used during the study include the standard deviation of the return on sales and standard deviation resulting from percentage change in operating income. Additional measures include standard deviation of the first difference in operating cash flow scaled by total assets and standard deviation of earnings before interest and tax to measure volatility. g) Ownership Structure and Managerial Shareholdings According to Qigui, Tian, and Xiaoming, 2011, p. 345, the optimal structure of leverage and ownership applies in minimizing the total agency costs. The leverage and ownership structure are related in that conflicts do exist between shareholders and managers and between shareholders and debtors. Therefore, leverage positively correlates to the extent of managerial equity ownership. h) Non-debt tax shields Non-debt tax shields refer to the tax deduction for depreciation and investment tax credits. These non-debt tax shields substitute tax benefits of debt financing and thus firms that consist of large non-debt tax shields use fewer debts. Both empirical and theoretical studies are in agreement with these findings. Sheng-quan (2009, p. 20) suggests that leverage is positively related to non-debt tax shields. The NTDS is determined by employing the sum of annual depreciation charges and investment tax credits divided by the sum of annual earnings before depreciation, interest and taxes. Factors affecting capital structure of real estate companies An empirical study carried out by Li, Luo and Ao (2011, p. 294) to investigate the factors that influence the capital structure of listed real estate firms in china showed that the following factors are involved: 1) Cash flow position The future cash flow position of the company is considered when making capital structure choice. The cash flow position of a real estate firm indicates the movement of money into and out of the business, Li (2010, p. 26). This information, according to the study, helps the firm to make a choice on when to use debit capital and when not to. For example, when the cash flow position of the firm is good, debt capital is used since many cash is needed in order to make payment of interest and refund of capital. The cash flow therefore affects the capital and its structure in the business 2) Interest coverage ratio The capacity of the real estate company to honor its debit payments is of great importance in shaping the firm’s capital structure. According to a study by Li (2010, p. 26), if the company has an interest coverage ratio that is less than one, it means the company does not generate enough cash through its operations and as a result, the business fails to meet its interest obligations. In such a scenario, the company should use cash on hand in making out the difference or when borrowing cash. Therefore, interest coverage ratio determines the number of times EBIT is available to the payment of interests. Debt capital is directly proportional to the interest coverage ratio. 3) Debt service coverage ratio The debt service coverage ratio shows the ability of a real estate firm to produce enough money to cover its debt payments. On calculating the ratio, a company can decide whether to obtain a loan or not. According to Dai (2011, p. 5), when the ratio is high, the company is in a better position to obtain loans. The property under the real estate firm is expected to sustain its debt based on the cash flow. This information is thus f great essence in real estate companies since it determines the choices taken by the firm in relation to the capital structure. 4) Return on investment The return on investment in real estate industry refers to the benefits that are accrued by the investors in a company. If the real estate company provides a greater return on investment, more investors will invest in the firm and this translates to more gains and an increase in the ability of the firm to utilize more debt capital. The capital structure in the real estate firm is thus affected by the increase in the number of investors and availability of debt capital from the investors. 5) Cost of debt The cost of debt plays a key role in structuring the capital of a real estate business. It provides the investors with details about the minimum return they should expect since they provide capital to the firm. From this information, a benchmark is set which the new firm must meet. The cost of debt helps a company to make decision on borrowing of funds from outside and taking of debts from financial institutions, .Lu (2010, p. 35) 6) Total assets This is the total amount of both current and long-term assets owned by the real estate company. The total assets are often looked at based on their ease of conversion into cash, Li (2010, p. 26). More liquid assets can remain easily sold for cash. the cash is used to run the business. The capital structure in the firm is greatly defined by the total assets available in the business. The total assets, furthermore determine if the business can obtain debt capital or not. 7) Tax rate The rate of tax can be presented in several ways: marginal, statutory, average or effective. The tax rate shows the ratio at which the real estate company is taxed. It affects the cost of debt. When the rate of tax is high, there is a decrease in the cost of debt, Dai (2011, p. 6). This is due to the reduction of interest on the debt capital from the profits considering it is a part of expenses. Major decisions involving the capital structure of the business should thus consider the tax rate being implemented. Several other factors were also identified from the empirical studies as the features affecting the capital structure of real estate businesses. They include: return on assets, leverage, tangible asset ratio, floatation costs, flexibility, risk consideration, regulatory framework, stock market conditions, control, capital structure of other companies and the management styles used, Dai (2011, p. 7). Conclusion Conclusively, the listed Chinese real estate firms choose equity financing first, then debt financing and their final option is internal financing. Most of these firms are state controlled and thus the firms can obtain capital by issuing of stocks that is relatively cheaper because minority shareholders do not demand high dividends. Secondly, for the big real estate firms, there is a negative relationship between size, growth, liquidity, profitability, tangibility and non-debt tax shields to the leverage ratio. 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