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Article Excerpt
Abstract. This paper attempts to investigate the determinants of the capital structure of a sample of 972 listed companies on the Shanghai Stock Exchange and Shenzhen Stock Exchange in China in 2003. Various theories, namely, the trade-off, pecking order and agency theories, are deployed to explain and predict the signs and significance of each factor identified by Ragan and Zingales (1995) and Booth et al. (2001). Furthermore, we include institutional shareholdings, including state agency shareholdings, state-owned shareholdings and privately owned shareholdings, as corporate governance variables to examine the effects of corporate structure on the debt financing behaviours. As well documented, we find that profitability is negatively related to capital structure at a highly significant level. The size and risk of the firms are positively related to the debt ratio--but only in term of market value measures of capital structure. The years of the companies being listed on stock markets are positively related to capital structure, indicating the access of the firms to debt finance is more easily judged by book value. Tax is not a factor in influencing debt ratio. Ownership structure has a negative effect on the capital structure. The firms with higher institutional shareholdings tend to avoid using debt financing, a behaviour that can be explained by entrenchment effects. A further classification of the institutional shareholders reveals that, among the three groups of institutional shareholding, the state institutions, including state agency and state-owned institutions, were more averse to debt financing, particularly for state-owned institutions. There is no strong evidence indicating debt-averse behaviour by domestic institutional shareholders.
JEL Classification Numbers: G31, G32
Key words: capital structure, ownership structure
1. Introduction
A good understanding of the determinants of firms' capital structures is still elusive (Barclay and Smith, 2005) notwithstanding the volume of research since the seminal 1958 paper of Modigliani and Miller (MM). Much of this research has focused on the relaxation of the assumptions made in the MM paper, and these extensions include variables such as taxes, bankruptcy costs, industrial characteristics, ownership structure and agency costs (Harris and Raviv, 1990). This research has also covered different economies with different institutional backgrounds. Rajan and Zingales (1995) found that the factors influencing the firms' capital structures in the United States and other industrialised countries were similar, although they failed to provide an underpinning theory. Booth et al. (2001) investigated firms' capital structures in developing countries, to see whether there were similar determinants as in developed economies. Their major finding was that a similar group of factors could explain capital structures, but that the persistent differences between the countries could only be understood with reference to the unique institutional structures of each country. With the increasing interest in corporate governance issues, the link between corporate governance and capital structure has also been attracting considerable theoretical attention (Jensen, 1986; Berger et al., 1997; Harvey et al., 2004).
The objective of this paper is to investigate the determinants of capital structure in Chinese firms. There have been only two previous studies of Chinese firms. Chen (2004) uses data for 1997, and does not allow for differences between industries. Huang and Song (2005) only consider a limited range of ownership structures, although they do consider industry effects. In this paper, we not only use a recent (2003) dataset of 972 firms and control for differences across nineteen different industrial sectors but also consider the impact of several different types of institutional shareholders More specifically, we classify the institutional shareholders according to whether they are (a) state agencies, which are government organisations exercising the functions of shareholders on behalf of the state; (b) state-owned institutions, which are entities controlled by governments at various hierarchic levels; and (c) domestic institutions, which are standalone entities set up by mixed groups of shareholders. This classification should shed light on the financing behaviour of listed companies with different types of large shareholders. Even more importantly, we combine insights from various strands of finance theory (notably agency theory, signalling theory and the theory of corporate control, as well as the timing of equity issues/purchases) to establish a more comprehensive model of the determinants of capital structure.
The structure of the paper is as follows. In section 2, we outline the theory of capital structure, beginning with the classic MM paper and then discussing various subsequent refinements and extensions. An econometric model to explain the debt ratio is developed in the following section, and we suggest the expected impacts of the various explanatory variables. The dataset is then identified, and the regression methods are described in section 4. Section 5 presents and discusses the empirical results from the regression analysis. Section 6 summarises the main findings.
2. Theory and Prior Empirical Evidence (1)
The modern theory of capital structure originated with the paper by Modigliani and Miller (1958) who demonstrated that, if investors can borrow and save on the same terms as firms, and if firms' financing decisions do not affect their total cash flows, then the firms' choice between debt and equity has no effect on their total market value. In other words, capital structure cannot create value unless it affects the total returns. This conclusion was based upon the rather restrictive assumptions that the capital market was perfect, and that there was no taxation. Furthermore, it is clear that in reality firms have very different capital structures. The MM model should thus be seen as a starting point for modelling more realistic scenarios which explain why debt might be used in preference to equity.
One early extension was to allow for the incidence of taxation and financial distress. Since the late 1970s, there have been two new strands of research which originate more from the theory of the firm: the 'pecking order' theory and the 'trade-off' theory. The pecking order theory argues that firms have a preference of issuing financing instruments due to adverse selection problems (Myers and Majluf, 1984). The theory suggests that the financial manager tends to use internal capital as the first choice, then issue debt, and equity will only be considered as the last resort as issuance of equity can be perceived by the market as a signal of a poor future for the investment. In contrast, the trade-off theory emphasises that an optimal capital structure can be achieved by the trade-off of the various benefits of debt and equity.
2.1. THE PECKING ORDER THEORY
The pecking order theory is based on the information asymmetries between the firm's managers and the outside investors. Ross (1977) was the first to address the function of debt as a signalling mechanism when there are information asymmetries between the firm's management and its investors. He argued that management has better knowledge of the firm than the investors, and that management will try to avoid debt when the firm is performing poorly for fear that any debt default due to poor cash flow will result in their job loss. The information asymmetry may also explain why existing investors may not favour new equity financing, as new investors may require higher returns to compensate for the risks of their investment thus diluting the returns to existing investors. Myers (1984) and Myers and Majluf (1984) later developed their so-called pecking order theory of financing: i.e. that capital structure will be driven by firms' desire to finance new investments preferably through the use of internal funds, then with low-risk debt, and with new equity only as a last resort. In their theory, there is no optimal capital structure that maximises the firm value. The financial managers issue debt or equity purely according to the costs of capital. Subsequent empirical studies provide mixed evidence. Helwege and Liang (1996) found no empirical evidence for such a pecking order. Booth et al. (2001) found evidence supporting the theory in their 10-country empirical study. Frank and Goyal (2003) tested the pecking order theory on a broad cross-section of publicly traded American firms for 1971 to 1998, and concluded that the theory was not supported by the evidence. Whilst large firms exhibited some aspects of pecking order behaviour, the evidence was not robust to the inclusion of conventional leverage factors, nor to the analysis of evidence from the 1990s.
2.2. THE TRADE-OFF THEORY
The trade-off theory argues that there is an optimal capital structure that maximises the firm value, but the trade-off comes in various forms.
2.2.1. Tax-Shield Benefits and the Financial Distress Cost of Debt
One of the crucial assumptions of the MM (1958) model was that there is no taxation. Later work by Modigliani and Miller (1963), and Miller (1977) add tax effects into the original framework. An implication of this newer work was that firms should finance their projects completely through debt in order to maximise corporate value. Clearly this contradicts reality in that debt constitutes only a fraction of firms' total capital. Subsequent theoretical work seeks an optimal capital structure which results from a trade-off between the benefits of tax shield of debt and the...
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