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Determinants of Capital Structure of Chi PDF
Determinants of Capital Structure of Chi PDF
Abstract
This paper develops a preliminary study to explore the determinants of capital structure of Chinese-listed companies using firm-level panel
data. The findings reflect the transitional nature of the Chinese corporate environment. They suggest that some of the insights from modern
finance theory of capital structure are portable to China in that certain firm-specific factors that are relevant for explaining capital structure in
developed economies are also relevant in China. However, neither the trade-off model nor the Pecking order hypothesis derived from the
Western settings provides convincing explanations for the capital choices of the Chinese firms. The capital choice decision of Chinese firms
seems to follow a ‘‘new Pecking order’’—retained profit, equity, and long-term debt. This is because the fundamental institutional assumptions
underpinning the Western models are not valid in China. These significant institutional differences and financial constraints in the banking
sector in China are the factors influencing firms’ leverage decision and they are at least as important as the firm-specific factors. The study has
laid some groundwork upon which a more detailed evaluation of Chinese firms’ capital structure could be based.
D 2003 Elsevier Inc. All rights reserved.
0148-2963/$ – see front matter D 2003 Elsevier Inc. All rights reserved.
doi:10.1016/S0148-2963(03)00070-5
1342 J.J. Chen / Journal of Business Research 57 (2004) 1341–1351
persistent differences of institutional structure across coun- structure for individual firms that results from a trade-off
tries indicating that specific country factors were at work. between the tax benefits of increasing leverage and increas-
Their findings suggest that although some of the insights ing agency and bankruptcy costs that higher debt entails.
from modern finance theory are portable across countries, Although remaining as the mainstream theory of capital
much remains to be done to understand the impact of structure, the trade-off theory has failed to explain the
different institutional features on capital structure choices. observed corporate behaviour particularly witnessed with
Booth et al. (2001) selected countries operating a market- the stock market reaction to leverage-increasing and lever-
orientated economic system, which bore many similarities to age-decreasing transactions, which consistently yields stock
developed countries. It is interesting and important to know price increases and decreases, respectively. As an alternative
how capital structure theories work in a transitional economy to the trade-off model, the Pecking order hypothesis of
environment within which institutional structures differ not corporate leverage emerged based on asymmetric informa-
only from developed countries but also from developing tion problems (Myers and Majluf, 1984). It predicts that
economies. The People’s Republic of China is the largest firms will prefer internal financing to issuing security, and,
developing and transitional economy in the world, and if forced to resort to external financing, will use debt before
therefore is chosen as the focus of this study. Since this is equity. This model explains many observed patterns in
the first examination of its type, the aim of this study is to corporate finance including the tendency of firms not to
develop some preliminary groundwork that a more detailed issue stock and their choice to hold surprisingly large cash
evaluation could be based. It is hoped to answer the question reserves and other forms of ‘‘financial slack.’’
whether, and how closely, does the determinants of Chinese Also derived from asymmetric information problems,
capital structure support the Western finance theory? More various signalling models of capital structure have also been
specifically: proposed, which suggest that managers use leverage to
signal firm prospects to poorly informed outside investors
1. Are firm-specific factors correlated with leverage that who believe these signals because they are prohibitively
have been identified in the Western settings also similarly costly for weak firms to mimic (Ross, 1977).
correlated in China? There have been many empirical studies attempting to
2. Does the institutional structure in China affect Chinese test the explanatory power of capital structure models on
firms’ capital choice decision? corporate behaviour in developed countries, particular in a
3. Do the Western capital structure models have robust ex- U.S. setting. Most of the work has been to identify the
planatory power for Chinese companies in the Chinese determinants of capital structure. The main determinants of
economy? capital structure tested include profitability, size, growth
opportunity, asset structure, costs of financial distress, and
The remainder of this paper is organised into five sec-
tions. Section 2 covers a brief literature review of the capital Table 1
structure debate. Section 3 provides background to the Summary of the implications of capital structure theories and empirical
Chinese institutional environment. The data collection and evidences on the relationship of capital structure determinants with gearing
research method are presented in Section 4. Section 5 Determinants Predicted sign Sample empirical evidence
discusses the regression results, and finally Section 6 con- by the theories
cludes the study with implications of the findings and Profitability (Pecking Kester (1986); Friend and Lang
suggestions for future research. order) (1988); Baskin (1989); Griner
and Gordon (1995); Shyam-
Sunder and Myers (1999)
+(trade-off, Bowen et al. (1982); Dammon
2. Review of capital structure debate signalling) and Senbet (1988); Givoly
et al. (1992)
In their landmark paper in 1958, Modigliani and Miller Size (Pecking Kester (1986); Titman and
(MM) showed that if a company’s investment policy was order) Wessels (1988)
taken as given, then in a world of perfect markets—a world +(trade-off, Marsh (1982); Rajan and
signalling) Zingales (1995); Chittenden
without taxes, perfect and credible disclosure of all informa- et al. (1996)
tion, and no transaction costs associated with raising money Growth (trade-off) Long and Malitz (1985)
or going bankruptcy—the extent of debt in a company’s opportunities ± (signalling, Titman and Wessels (1988);
capital structure would not affect the firm’s value. The Pecking order) Lang et al. (1996)
perfect capital markets they assumed have attracted a wide Asset structure +(trade-off) Long and Malitz (1985);
+(Pecking order) Chung (1993); Walsh and Ryan
variety of research of somewhat-less-than-perfect capital (1997)
markets. The development of agency theory in the 1980s, Cost of financial (trade-off) Bradley et al. (1984); Friend
coupled with detailed research into the extent and effects of distress and Lang (1988); Walsh and
bankruptcy costs, has lead to the current mainstream view Ryan (1997)
that corporations act as if there is a unique, optimal capital Tax shields effects +(trade-off) Bradley et al. (1984)
J.J. Chen / Journal of Business Research 57 (2004) 1341–1351 1343
small, thus, giving little cause for concern about the problem 4.5. Comparison of the models
of multicollinearity among the independent variables.
The estimation results are reported in Tables 4 and 5. The
4.4. Regression models fixed effects model has a slight statistical advantage over the
other two models. It has the lowest RMSE and the highest R2
Since the sample contains data across firms and over time, for both the total and long-term leverage equations. For the
the panel data method is employed. The basic regression joint test, all of the three models for LEV and LLEV are
model can be specified as follows: significant at a 5% critical level and they produce quite
similar results for profit, growth opportunities, and earning
yit ¼ þ X0it B þ uit i ¼ 1; . . . . . . ; 77; t ¼ 1; . . . . . . ; 6 volatility variables.
The Hausman specification test is employed to test the
where i denotes the cross-section dimension and t indicates fixed effects model versus the random effects model. The
the time dimension, Xit0 is a 1 k vector of observations on k test statistic for the total leverage equation is 15.77. The
explanatory variables for the ith firm in the tth period, B is a test is asymptotically 2 distributed with seven degrees of
k 1 vector of parameters, uit is a disturbance term and is freedom. The random effects model can be rejected in
defined as favour of the fixed effects model at a 5% critical level.
For the long-term leverage equation, the Hausman stat-
uit ¼ i þ vit istic is 9.78, which indicates that the null hypothesis
where i denotes the unobservable individual effect and vit cannot be rejected at any conventional level of signific-
ance. However, as it can be seem from Table 5, the R2
denotes the remainder disturbance. Three methods, pooled
among the three models is extremely low although the
OLS, fixed effects, and random effects, are used.
Wald joint tests for the models are significant at a 5%
critical level.
Table 5
Three different estimators of LLEV equation
Dependent variable: LLEV 5. Results and discussion
Independent Fixed effects Random effects Pooled OLS
variables 5.1. Regression results
PROF 0.0566 * 0.0624 * * 0.0878 *
(0.0306) (0.0303) (0.0501) The empirical evidence obtained has suggested that the
SIZE 0.0312* * * 0.0230 * * 0.0059 coefficients of profitability and growth opportunities are
(0.0115) (0.0101) (0.0087)
GROWTA 0.0278* * * 0.0249 * * 0.0019
significant for the total leverage regression (Table 4). The
(0.0103) (0.0103) (0.0174) coefficients of profitability, growth opportunities, tangib-
TANG 0.0837* * * 0.0862* * * 0.0755* * * ility, and size are significant for the long-term leverage
(0.0265) (0.0246) (0.0264) (Table 5). It shows that the three models offer quite similar
EVOL 0.0003 0.0002 0.0002 results but slightly different levels of significance in both the
(0.0008) (0.0008) (0.0014)
NDTS 0.0840 0.0604 0.0601
total and long-term leverage estimators. The significant
(0.0571) (0.0539) (0.0606) exception is that the coefficient of size is negative and
DUM / 0.0120 0.0146 highly significant in the long-tem leverage estimation but
(0.0209) (0.0095) positive in the total leverage estimation. However, it can be
_CONS 0.3014* * * 0.2204 * * 0.0819 argued that the positive coefficient of size for the total debt
(0.0999) (0.0891) (0.0760)
No. of 462 462 462
ratio is not significant in the fixed effects model. Therefore,
observations it could be concluded that large firms use more short-term
R2 .0698 .0550 .0562 finance and less long-term finance.
F statistic 4.0500 / 3.3700 Having further corroborated the relationships between
Probability>F (.0003) / (.0009) the significant explanatory variables and the dependent
Wald 2 15.5000 26.3400 16.5600
Probability>2 (.0500) (.0010) (.0350)
variables, it is found that:
AR(1) test: 2.9560 10.0400 2.8610
(0.0030) (0.0000) (0.0040) 1. there is a negative relationship between profitability and
AR(2) test: 3.0310 0.4374 2.6440 debt;
(0.0020) (0.6620) (0.0080) 2. a positive relationship exists between growth opportunity
Root MSE 0.0481 0.0482 0.0924
and debt;
Standard errors in parentheses are for coefficient and P values for 3. there is a positive relationship between tangibility and
diagnostic test.
* Significant at 10% level.
debt;
* * Significant at 5% level. 4. a negative relation exists between a firm’s size and long-
* * * Significant at 1% level. term debt.
1346 J.J. Chen / Journal of Business Research 57 (2004) 1341–1351
additional capital. A new Pecking order of Chinese-listed for debt to reduce lender’s risk (Williamson, 1988, 1975).
firms’ leverage thus appears—retained profit, then equity Agency theory also predicts the same relationship (Jensen
finance, and lastly debt. and Meckling, 1976). The agency costs of equity lead to
underinvestment problems. Further, the information asym-
5.2.3. Growth opportunities metry results in new equity being underpriced. Issuing debt
Another factor, which is supposed to affect capital struc- secured by tangible assets reduces these agency costs. This
ture, is growth potential. A positive relationship between study confirms this positive relationship between a firm’s
growth opportunities and debt in China is found, which leverage, particular long-term debt, and the tangibility of its
confirms the same relationship found in developed countries assets. It shows that asset tangibility is an important criterion
except the United States (Wald, 1999). in banks’ credit policy, and this is particularly true for long-
According to the trade-off theory, firms holding future term loans. This result is consistent with both the trade-off
growth opportunities, which are a form of intangible assets, model in terms of financial distress and bankruptcy costs and
tend to borrow less than firms holding more tangible assets the Pecking order hypothesis in terms of asset mispricing.
because growth opportunities cannot be collateralised. Fur-
ther, agency theory argues that firms have a tendency to 5.2.5. Size
expropriate wealth from debtholders (Myers, 1977; Jensen, Theoretically, the relationship between size and lever-
1986). Firms with greater growth opportunities have more age is unclear. According to the trade-off model, large
flexibility to invest suboptimally, and thus expropriate firms are expected to have a higher debt capacity and are
wealth from debtholders to shareholders because of the asset able to be more highly geared. Large firms are more
substitution effect. Ongoing growth opportunities imply a diversified, thus, less exposed to the risk of bankruptcy.
conflict between debt and equity interests. Therefore, a They may also be able to reduce transaction costs asso-
negative relationship is expected between debt and growth ciated with long-term debt issuance. Another possibility is
opportunities. that larger firms may have a more dilute ownership, and
However, the trade-off model does not apply to the thus have less control over individual managers. Managers
Chinese firms. One reason may be that most of the listed may then issue debt to reduce the risk of personal loss
firms are in the manufacturing and heavy industry sectors. resulting from bankruptcy (Friend and Lang, 1988).
They possess more tangible assets and less intangible assets Marsh’s (1982) survey of the literature concluded that
such as good will, R&D, and advertising, and thus have large firms more often chose long-term debt while small
limited growth opportunities. This is a reflection of the firms chose short-term debt. Rajan and Zingales (1995)
generally low technology level of Chinese firms. and Wald (1999) suggested that size was positively
Another reason may be that the equity market recog- correlated with debt based on the data from developed
nises the value of growth opportunities, so do banks. This countries with Germany as an exception.
recognition has been reflected in share prices. According However, when size is used as a proxy for the (inverse)
to the signalling model, high-value firms are able to use probability of default, it should not be strongly positively
more debt financing because debt has its dead weight related with leverage in countries where costs of financial
costs, which make less valuable companies more likely to distress are low. Furthermore, according to the Pecking
fall into bankruptcy (Ross, 1977). The signalling model order hypothesis, informational asymmetries between
generally predicts that the firms with the best earnings and insiders within a firm and capital markets are expected to
growth prospects will employ the most leverage. Lang et be lower for large firms so large firms should be more
al. (1996) further argued that leverage was negatively capable of issuing informationally sensitive securities like
related to growth opportunities only for firms whose equity (Kester, 1986). Titman and Wessels (1988) both
growth opportunities were not recognised by the capital found evidence to support the negative hypothesis between
market. The high market capitalisation in China may size and leverage.
indicate that the growth opportunities associated with The relationship of firm size to total debt in Chinese
listed firms have been recognised by the capital market; firms produces a positive value, but this result is not
therefore, banks are willing to assign higher valuations to statistically significant in the fixed effects model. However,
highly levered firms and issue more long-term debt to the coefficient of size to long-term debt is negative and
finance the firms’ growth opportunities. highly significant, which suggests that firm size has a
negative relationship with long-term debt. This negative
5.2.4. Tangibility relationship, however, may not be the result of informational
Much research examining the correlation between lever- asymmetries suggested by Myers and Majluf (1984)
age and tangibility in developed and developing countries has because the market capitalisation of equity in China is very
proved that a positive relationship exists because tangible high; thus, undervalution of new equity may not be a
assets are easy to collateralise for debt. From the viewpoint of concern. The negative relationship between size and long-
transaction cost economics, tangible assets usually have less term debt may be due to the fact that large firms have better
asset specificity, thus, increasing their use as collateralisation access to capital markets for equity finance because of their
1348 J.J. Chen / Journal of Business Research 57 (2004) 1341–1351
reputation in the markets and the attraction of the capital This is because the fundamental institutional assumptions
gains in the secondary markets. It may also be because the underpinning the Western models are not valid in China.
bankruptcy costs are low in China since legal system is The capital choice decisions of Chinese firms seem to
incomplete and yet to be implemented. There is no protec- follow a ‘‘new Pecking order’’—retained profit, then
tion of debtholders especially in the event of default. The equity, and lastly debt. The management of the firms
asset substitution problem prevails. Public bond market prefers equity financing rather than debt financing
virtually does not exist. because the former is not binding. The results imply that
It can be further argued that agency theory (Jensen, 1986) significant institutional differences such as the legal
and transaction cost economics (Williamson, 1988) suggest system governing companies’ operation and banking and
that large firms issue more long-term debt because they use securities markets, ownership concentration and the cor-
debt to better control management behaviours due to more porate governance structure of the listed firms, the agency
dilute ownership. However, smaller firms are more subject problems inheriting from public ownership, and the fin-
to shareholder intervention in the case of mismanagement ancial constraints in the banking sector are all factors
because a reasonably small group of shareholders can gain a influencing the roles of firm-specific factors on firms’
controlling interest in the firm, as with small U.S. firms. The leverage decision. Knowing these differences are at least
corporate governance in the Chinese firms, in this respect, is as important as knowing the firm-specific factors they
much like small U.S. companies in this way. The Chinese measure.
government still owns a significant proportion of the com- The above findings have reflected the transitional nature
panies’ shares, and thus is the major stakeholder of the of the Chinese corporate environment. On the one hand, the
firms. Therefore, in China, small numbers of professional trade-off model has limited explanatory power in China in
managers, usually selected by the state, control a sizeable that, for example, the effects costs of financial distress
percentage of the listed firms’ stock and can force manage- (earning volatility, bankruptcy costs) are not significant.
ment to act in the shareholders’ interests. If size proxies for This is because the Chinese environment still keeps some
the relative dilution of control, the Chinese firms would features of a centrally planned economy. The state is still the
appear more like small U.S. companies. The result may principal stakeholder of firms and the owner of banks as
suggest that the centralised state control (state controlled well as the beneficiary of tax. If the state does not change its
shares) is responsible for the negative relationship between controlling behaviour towards corporatised SOEs, those
size and long-term debt. firms are less likely to run into financial crisis compared
with their counterparts in private sectors, so the costs of
financial distress is likely to have much less effect on firms’
6. Conclusion capital structure. On the other hand, certain firm-specific
factors that affect firms’ leverage in the Western countries
A remarkable difference between the capital choices of also affect Chinese companies’ leverage. This has shown
Chinese firms and firms in developed economies is that that Chinese-listed firms have followed the basic rules of a
Chinese firms prefer short-term finance and have substan- market economy despite the state controlling ownership.
tially lower amounts of long-term debt. To the extent that The business operation of these companies has shown a
theories of capital structure explain capital choices of firms profit-oriented nature.
in developed countries, this difference, in long- versus short- This paper has laid some groundwork to explore the
term debt, might limit their explanatory power in China. It determinants of capital structure of Chinese-listed compan-
suggests that the theoretical underpinnings of the observed ies upon which a more detailed evaluation could be based.
correlations are still largely unresolved. Further work is required to develop new hypotheses for the
The results of this empirical study suggest that some of capital choice decisions of Chinese firms and to design new
the insights from modern finance theory are portable to variables to reflect the institutional influence. A larger,
China in that certain firm-specific factors that are relevant comprehensive, and detailed database is also required for
for explaining capital structure in the Western countries are a further detailed capital structure study. In addition, this
also relevant in China. This is true despite profound insti- study has also established a correspondence between cor-
tutional differences that exist between China and the West- porate governance of the firms and capital markets, though
ern countries. Knowing these factors could help predict the preliminary, which should be further studied.
financial structure of a firm. The Pecking order model along
with asymmetric information theory seems to provide partial
explanations. Acknowledgements
However, a further investigation of firm-specific factors
correlated with leverage has shown that neither the trade- I would like to thank the two anonymous referees for
off model nor the Pecking order hypothesis derived from their detailed comments and suggestions, which improved
the Western settings has robust explanatory power in the quality of the paper. I am also grateful to Mr. Lichun
explaining the capital choice preference of Chinese firms. Zhang for his assistance on data collection.
J.J. Chen / Journal of Business Research 57 (2004) 1341–1351 1349
Appendix A
Table A1
LEV ratios
Ratios 1995 1996 1997 1998 1999 2000
LEV—Shenzhen
Mean 0.47131 0.46499 0.465352 0.454139 0.482438 0.55289
Median 0.533086 0.565761 0.498039 0.479479 0.522476 0.492388
S.D. 0.185249 0.187243 0.185411 0.240659 0.233648 0.369384
Minimum 0.113138 0.101311 0.141902 0.123601 0.117825 0.091919
Maximum 0.732885 0.699301 0.727202 1.041552 1.009489 1.800815
Count 23 23 23 23 23 23
LEV—Shanghai
Mean 0.447135 0.443107 0.417574 0.440641 0.452509 0.453046
Median 0.446125 0.435627 0.449763 0.413973 0.444713 0.449983
S.D. 0.177024 0.16367 0.17293 0.155476 0.176448 0.162636
Minimum 0.056372 0.083162 0.044308 0.085425 0.061965 0.030021
Maximum 0.81683 0.825065 0.790175 0.763757 0.920417 0.717421
Count 54 54 54 54 54 54
LEV—all sample
Mean 0.454356 0.449644 0.431845 0.444673 0.461449 0.482869
Median 0.46318 0.452391 0.460732 0.418361 0.460271 0.45828
S.D. 0.178639 0.170093 0.176891 0.18347 0.194177 0.245069
Minimum 0.056372 0.083162 0.044308 0.085425 0.061965 0.030021
Maximum 0.81683 0.825065 0.790175 1.041552 1.009489 1.800815
Count 77 77 77 77 77 77
Table A2
LLEV ratios
Ratios 1995 1996 1997 1998 1999 2000
LLEV—Shenzhen
Mean 0.06575 0.058462 0.05669 0.052137 0.055831 0.066501
Median 0.042836 0.026637 0.026523 0.0341 0.027317 0.052858
S.D. 0.110109 0.09114 0.084637 0.069144 0.085694 0.072182
Minimum 0 0 0.01801 0.01825 0.04251 0.04213
Maximum 0.530289 0.425444 0.3792 0.30965 0.348233 0.256729
Count 23 23 23 23 23 23
LLEV—Shanghai
Mean 0.086394 0.075027 0.074953 0.068855 0.064982 0.062883
Median 0.062835 0.037136 0.032973 0.017354 0.026104 0.029058
S.D. 0.101583 0.100604 0.10513 0.100353 0.097055 0.083504
Minimum 1.4e 05 0 0 0.00294 0.01706 0.00527
Maximum 0.493803 0.480632 0.423549 0.484013 0.458667 0.404255
Count 54 54 54 54 54 54
LLEV—all sample
Mean 0.080227 0.070079 0.069498 0.063862 0.062248 0.063964
Median 0.055644 0.035425 0.032828 0.020193 0.027077 0.035286
S.D. 0.103905 0.097575 0.099257 0.092012 0.09334 0.079835
Minimum 1.4e 05 0 0.01801 0.01825 0.04251 0.04213
Maximum 0.530289 0.480632 0.423549 0.484013 0.458667 0.404255
Count 77 77 77 77 77 77
1350 J.J. Chen / Journal of Business Research 57 (2004) 1341–1351
Table A3
Summary statistics
Variable Observations Mean S.D. Minimum Maximum
LEV 462 0.4541394 0.1926236 0.0300211 1.800815
LLEV 462 0.0683129 0.0943057 0.042512 0.530289
PROF 462 0.0509647 0.1028456 1.466707 0.310276
SIZE 462 8.807845 0.535916 6.827678 10.31107
GROWTNO 462 0.2690713 1.427961 0.942656 22.13457
GROWTA 462 0.1701884 0.2688143 0.545685 1.838353
TANG 462 0.4946659 0.1767652 0.0155384 0.909136
EVOL 462 1.122254 3.313855 0.0006839 37.98547
NDTS 462 0.772868 0.0774104 0.0002099 0.742314
DUM 462 0.7012987 0.4581847 0 1
Table A4
Correlation matrix
LEV LLEV PROF SIZE GROWTA TANG EVOL NDTS
LEV 1.000
LLEV .3291 1.0000
(7.4722)* * *
PROF .5213 .1181 1.0000
( 11.8329)* * * ( 2.5486)* * *
SIZE .0843 .0032 .1711 1.0000
(1.8080) * * (0.0643) (3.7224)* * *
GROWTA .1131 .0434 .3633 .0622 1.000
( 2.4392)* * * ( 0.9231) (8.3554)* * * (1.3323) *
TANG .0854 .1751 .0644 .1953 .0812 .0233 1.0000
(1.8297) * * (3.8122)* * * ( 1.3754 )* (4.2641)* * * ( 1.7430) * * (0.4934)
EVOL .1801 .0372 .4013 .0082 .1881 1.0000
(3.9247)* * * (0.7941) ( 9.3883)* * * ( 0.1716) ( 4.1053)* * *
NDTS .0751 .1023 .1041 .2321 .1112 .0972 .3231 1.0000
( 1.6131) * (2.1991) * * ( 2.2427) * * (5.1154)* * * ( 2.3955)* * * (2.0903) * * (7.3199)* * *
* Significant at 10% level.
* * Significant at 5% level.
* * * Significant at 1% level.
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