The Capital Structure of Chinese Companies - Literature review Example

The capital structure of Chinese Firms: a literature review Introduction The debates about the capital structure of firma can be traced to the landmark findings of Modigliani and Miller in 1958 and subsequently in 1963 about the impact of leverage on firm value, the research findings showed that in a perfect economy with zero transaction costs and no taxes, the level of indebted ness of the company will not affect the value of that firm. After this there have been more theoretical frameworks that have been brought up to explain the capital structure policies and decision of the firm. Presently, there exist the agency theory of capital structure, the pecking order theory, the tradeoff theory, equity timing hypothesis and the Modigliani and Miller hypothesis. Most research has concentrated on relating these theories to the capital structure especially in the developed economies. The empirical analysis of the capital structure has also been developed to identify the explanatory powers of the theories. However, this debate has been concentrated on the developed countries and not much research on the developing countries. A case in point is China. The economic environment of China provides an opportunity to explore given the revolutionary changes the Chinese economy has had in the recent times: from State Owned Organisations to private companies, the development of a financial market. With such past economic environment and the developing of the country into an economic giant is uncertain how the theories reflect the capital structure of the firms in China (. This paper will therefore review literature on the capital structure determinants and policies in general and an empirical analysis review on studies done to explain the capital stricture policies of Chinese companies in the recent past. Literature Review Song (2005) defines the capital structure of a firm as the combination of securities, that are either its debt or equity instruments (Modigliani and Miller 1958) that a firm uses to finance its assets. It is the means through which a company finances its operating activities. Therefore the theories of capital structure ty to explain why a firm would consider certain combination of these instruments and neglect the other. Such of these theories is the pecking order theory, agency cost theory, Modigliani and Miller hypothesis and the equity timing hypothesis. The pecking order theory\ The pecking order theory was developed through the works of Myers and Majluf (1984) and Myers (1984). The theory implies that the manager’s perception of the firm value will always take precedence over the external user’s perception (Ni et al 2009). Put differently, the theory suggests that a firm will only seek external financing once it has exhausted its internal finances. The implication of the theory is that there is an order in which a firm will seek out financing and it will only use another financing mechanism when that which takes precedence can no longer be used. The theory is based on the asymmetry of information between the managers and the investors: managers will issue the firms securities when they think it is overvalued while the investors will interpret undervalue which will eventually bring the prices of the shares to their true levels. Ni and Yu (2008) disagree with this theory when they found that Chinese firma do not follow a pecking order when picking sources of finances for their investments. The research also revealed that pecking order is applied by large firms as opposed to small firms. Modigliani and Miller Hypothesis: Irrelevance theory The maiden capital structure theory by Modigliani and Miller suggest that the capital structure of a firm is of no importance to the value of the firm, in a complete perfect market. The theory assumes that the transactions costs of the company and the taxes are at zero levels. The theory is not practical as there are no perfect markets that exist and firms will always incur transactions costs. The theory suggest with taxes there can be obtained an optimal level of leverage for any firm given that tax deductions lower the amount payable in interests( Chen et al 2011). Marketing Timing Theory The market timing/equity timing hypothesis, developed by Baker and Wurgler (2002) proposes that the timing of issue of securities determines the shareholders’ value and the firm value. This theory suggests that firma will issue their securities when prices are overvalued and when undervalued the firm will buy back its shares. Past research done shows no consistency in the impact of the theory on capital structure, especially within the Chinese market. There is evidence that the marketing timing hypothesis has little impact on the capital structure of the Chinese firms, especially in the long term (Hu et al 2008). Russel and Hung (2013) found that equity timing hypothesis has no persistent impact on capital structure and that this impact only ends within the third year. Consistent is the results of Zhang and Tang (2006) that this long term effect is not significant. Agency Theory The agency theory of capital structure was developed by Jensen and Meckling (1976) and explains that managers behavior could be self-motivated which could be at the expense of the shareholders and should therefore be regulated. Therefore corporate decisions, capital structure policy, by managers are fueled by the agency problem between them and the shareholder. In particular, there existent optimal levels of debt for the shareholders one which the mangers will exceed at their own benefit but would hurt the shareholders. In order to regulate such behaviors, the firm will have to incur costs. However the more dominant the management is the more difficult it is for shareholders to monitor their activities (Huang et al 2016). There is evidence that indeed the agency conflicts and costs impact on the capital structure decision of the firm. Harris and Raviv (1988) in Huang et al (2016) found that entrenchment motives of managers increase the probability of firm mangers to take debt financing. Huang et al (2016) enforces that self-serving managers are not responsible for making capital making decisions: the research showed that the capital structure decisions of SMEs in China is positively related to their corporate governance mechanism such as cash compensation. Trade off Strategy The trade-off theory of capital structure is based on the tax benefits that a firm enjoys when it is leveraged. In theory, a firm will pursue an optimal capital structure depending on the marginal cost and benefits of external financing (Tong and Green 2004). Debt is considered being beneficial to the extent that the firm can provide the tax shield and reduced monitoring costs. Studies of US firms by Fama and French (2002) show there is indeed some relationship between the tax shield and the debt financing of the company. Research by Tong and Green (2004) showed that there is evidence that Chinese firms prefer the pecking order theory over the tradeoff theory. However, Chen (2004) found no conclusive evidence that the tradeoff theory has explanatory powers in the capital structure decisions of the Chinese firms. The theory suggests that those firms that have the least financial costs/ distress are expected to have the highest level of debt. Empirical Analysis Review Given the diverse amount of theories explaining the determinants of capital structure has been to estimate the explanatory powers of the theories. The capital structure of a firm is estimated by the leverage level of the company: both in the short term and long term. In all research, the leverage is the dependent variable. The leverage of a firm can be measured either using the overall leverage (the book value debt ratio); long term leverage (book value ratio of long term debt to total assets). Other research have used only debt ratio as the index of capital structure (Ren and Zhuang 2009). The Empirical analysis review adopts the regression model developed by Lim et al (2012). In regression model in general will take the form: The leverage ratio is represented by Y, Using the determinants from previous literature, this review will analyses the regression model, a modification of the regression model by Lim et al (2012): Where are the determinants profitability, size, tangibility and growth at time t and for firm i. ids the dummy variable for firm belonging to industry j=2,…n where d=1 is for a firm belonging to either category and d=0 otherwise while is the time specific effect of each firm. The term is the time and firm specific error term. The independent variables are the ones that are defined as the determinants of capital structure. The main determinants that have been tested include: profitability, size, asset structure, tax shield effects (Jen 2004) and growth opportunity (Chen et al n.d). Other studies have also included liquidity, macroeconomic factors, and dividend as determinants of capital structure (Yang et al 2015). the cooperation size is usually measured by the asset index (Ren and Zhuang 2009) or the logarithm of total assets (Chen 2004), tangibility as the ratio of capital assets to stocks (Ren and Zhuang 2009) while Chen (200) measured asset structure as the ratio of tangible assets to total assets while the ratio of sales to total assets growth Jen (2004) , using regression analysis of the determinants of capital structure in Chinese firms, found that profitability and growth opportunity to have significant effect on the total leverage of the firm while long term leverage is significantly affected by the profitability, growth opportunity, size and tangibility of the form. The firm size of a firm is one of the critical elements in deciding the ability of a firm to acquire debt. The logic behind this is large firms have a low risk of default due to high profitability hence can have access to debt financing (Fama and French 2005). Furthermore, the larger the size of the company, the better its ability to cover the transaction costs incurred in debt financing hence are assumed to be highly levered that small firms (Chen 2004). Tong and Green (2004) estimated a positive relationship between the size of the firm and the level of indebtedness. This, they noted, was an implication of the tradeoff theory that suggests that firms will only seek external financing if the benefits of debt exceeds the costs of debts financing. Other research show the reverse: firm size is inversely proportional to long term leverage (Jen 2004). Titman and Wessel (1988) on their analysis of US firms also found that the larger the size of the firms the lower the leverage of that firm. The profitability factor follows the pecking order and the agency theory predictions. The pecking order theory suggest that firms with higher profitability will have less debt levels while agency theory argues that profitable firms will have higher debt ratios to as to mitigate the manager’s vulnerability to misuse the funds (Jensen 1986; Yang et al 2015). However the research b Jen (2004) showed that there is a negative relationship between profitability and the debt leverage of a company, the results were confirmed by Lim et al (2012). Tong and Green (2004) determined the capital structure of firms as determined by size, growth and profitability of the firm. The results showed that the coefficient of profitability in the regression model was negative: that is there is a negative relationship between profitability and leverage. Results are consistent with the implication of the pecking order theory. However, Chen (2004) adds that this relationship could be as a result of other factors such as the state control and the underdevelopment of the financial and bond market. Lim et al (2012) in an analysis of 256 listed Chines firms found that the factors f size, growth and tangibility not to be significant at 0.01 statistical level. There is evidence to show that there exists a positive relationship between growth opportunities and capital structure (Chen 2004). This is consistent with the predictions of the pecking order theory that suggest that firms with higher growth opportunities are likely to increase their level of debt. The same results were seen following a research on US firms (Wald 1999). On the other hand, trade off theory suggests that high growth opportunity increases the financial distress of the company. Chen (2004) confirmed that indeed there is a positive relationship between growth opportunity and debt levels. The other determinant of capital structure as predicted by literature is the tangibility factor. Research shows that tangibility positively affects the debt levels of a firm: the more the tangible assets a company have the higher their ability to produce collateral for debt financing (Chen 2004). The study by Chen (2004) on banks showed that tangibility is an important aspect in determining the credit policy hence a determinant in the capital structure decisions. Chen et al (2011) found that there is a positive link between intangibility and total debt ratio the research shows that the industry in which the company operates also affects the capitals structure decision of the firm. There is further evidence that the ownership structure of the company has considerable impact on the capital structure of the firm it is especially true considering the Chinese is a transition economy from state owned organization to private organisations. Conclusions The theoretical framework shows that there exist five theories that can predict the capital structure decision of firms in the market: equity timing hypothesis, M & M hypothesis, the agency theory, the tradeoff theory and the pecking order theory. These theories work well within the environment of developed economies but they show inconsistent result in developing economies and especially so within the developing and transitioned economies such as China. Literature provided shows that the pecking order and the tradeoff theory are dominant in explaining the financing decisions of Chinese firms. However, the results are inconsistent: neither of the theories has enough explanatory power to the debt financing decisions in China. These differences in the results from China to developed economies are the institutional framework (Chen 2004), the developing financial market and the state of transition of the Chinese economy. Chen (2200) suggests that the Chinese firms are adopting a new pecking order hypothesis in which capitals structure follows the order: profits, equity and finally debt. This is aggravated by the fact that Chines firms prefer short term debt financing than long-term financing. There is therefore need to research on the gap that is provided by this new hypothesis in practice. References Baker M and Wurgler J 2002 Market Timing and Capital structure Journal of Finance vol 57 pp1-32 Fama F and French F 2005 Financing Decisions: Who issues stock? Journal of Financial Economics vol. 76 pp59-582 Hu J, Yan Y and Deng T 2008 Market timing and Capital structure: Evidence from China Journal of Finance theory and Practice vol 3. Pp7-10 Huang W, Boateng A and Newman A 2016 Capital structure of Chinese listed SMEs: an agency theory perspective Small Business Economics August 2016 Vol. 47 issue 2 pp 535-550 Jen J 2004 Determinants of Capital Structure of Chinese –listed companies Journal of Business Research Vol. 57 2004 1341-1351 Jensen C and Meckling H 1976 Theory of the firm: managerial behavior, agency costs and the ownership structure Journal of Financial Economics vol 3 pp 305-360 Lim C, Chai R, Zhao D and Lim Y X 2012 Capital structure and political patronage: Evidence from China American Journal of Business and Management vol 1 no. 2012 pp 177-182 Modigliani F and Miller M 1958 The Cost of Capital, corporation finance and the theory of investment An Economic Review Ni J and Yu M 2008 Testing the Pecking Order Theory: evidence from Chinese Companies. Chinese Economy Journal vol. 41 January 2008 pp 97-113 Russel P and Hung K 2013 Does Market Timing Affect Capital Structure? 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