CAPITAL STRUCTURE AND FIRM PERFORMANCE:
A CASE OF LISTED COMPANIES IN THE CHINESE STOCK EXCHANGE
Capital structure refers to the firm's financial framework. It is a combination of debt, equity, hybrid securities and other sources of finance used to run the activities of the firm. The choice of capital structure is important for any organisational set-up, in order to maximise returns to different stakeholders and also because of the effect such a choice has on an organisation's ability to survive amidst competition. Choosing the right financial mix is therefore a crucial decision as it involves balancing the anticipated risks with the expected profit.
Myers (1984) in his popular view opined that the yardstick firms use in choosing their capital structure is unknown to us. This is still true despite the theories that have been developed to understand what an optimal capital structure entails. An optimal capital structure is usually defined as one which will minimise an organisation's risk i.e. reduce its weighted average cost of capital, while at the same time maximising firm value. Exactly how firms choose the capital structure mix remains a puzzle. The answer to this question is very important because the decision of managers will affect the growth and performance of the firm and also influence how investors view the firm.
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The business environment in China has some distinguishing features that make it an interesting focal point. China is transforming from a centrally-planned economy to a free market economy and has achieved great success in economic development as well as attracting a great deal of foreign investors. It should be noted that China has possesses institutional structure that are quite different from developed countries. This is so because despite the transformation from command economy where government was in total control of the economy, to market economy, the government still has considerable influence on the economy. As Huang et al (2005) put it, because of the influence the state wields in most listed companies; it makes their capital structure choice irrelevant since the government wades in when there is a problem. Many of the initial setbacks of market transformation have been overcome. The dominant economic institution in China is the market, hence the choice of China as the focal point of the research. The challenges being faced in Chinese economy have moved from transition to development – Naughton (2007).The drive to invest in human capacity and infrastructure as well as create efficient institutions that would be the mainstay of the economy are some of the challenges faced by the Chinese economy.
Most modern theories on capital structure owe their existence to the celebrated paper of Miller & Modigliani (1958). They argued that in a perfect market,( i.e. no tax, no bankruptcy costs, and asymmetric information), the actual value of a company depends on its income flow and the degree of risk, regardless of its debt-equity mix and that any imperfection will be quickly wiped out by the market. Miller & Modigliani (1963) further included taxes in their analysis and found out that a firm's overall value increases with debt. There are useful theories that help to explain the choice of capital structure of companies. They are the trade-off theory and the pecking order theory.
The trade-off theory states that firms seek to balance the tax gains or benefits from borrowing against the risk of financial distress. At this point the firm is said to be operating an optimal capital structure. The problem of agency costs has been explored by Jensen and Meckling (1976). Managers are agents of shareholders and are expected to act in their best interests. However, they have daily control over the business and the shareholders do not have adequate information on whether their best interests are being served by the managers. – Pike & Neale (2006). The impact of agency costs is that debt providers demand abnormal interest rate thereby making debt expensive.
As the Debt equity ratio (i.e. leverage) increases, there is a trade-off between the interest tax shield and bankruptcy, causing an optimum capital structure, (http://en.wikipedia.org/wiki/Trade-Off_Theory_of_Capital_ Structure)
The empirical support for the trade-off theory is inconclusive. While Miller & Modigliani (1966), Schwartz & Aronson (1967), Bradley et al (1984) find evidence in favour of the trade-off theory, Titman & Wessels (1988) found mixed evidence. Long & Malitz (1985) found no evidence – See Myers & Sunder (1984).
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The pecking order theory of capital structure emanates from the problem of information asymmetry. Myers (1984) opined that because of adverse selection problem, firms prefer internal finance to external finance. When external funds are required, firms prefer to issue debt which is less risky than equity- see Frank & Goyal (2003). Equity is only issued as a last resort because the decision to issue equity signals bad news – Myers (1984). The implication of the pecking order theory is that firms do not have a particular target capital structure. The empirical support for the pecking order theory is equally mixed. Sunder & Myers (1999) sampled 157 public firms in the United States and found evidence of the pecking order theory. Myers (2001) supports this view – see Frank& Goyal (2003). Research on the impact of profitability on the leverage of firms has also been carried out. Kester (1986), Titman & Wessels (1988), Rajan & Zingales (1995) and Wald (1999), found inverse relationship between leverage and profitability. While we are unable to perfectly answer the question posed by Myers (1984) about how companies choose their capital structures, there is little empirical evidence to show the determinants of capital structure choice. Harris & Raviv (1991), report that firm specific factors such as firm size, asset tangibility, and investment opportunities affect leverage. Antoniou et al (2008), in agreeing to that, further added that financial orientation of the economy as well as macro economic factors affect the capital structure of the firm.
Previous research on capital structure has been carried out in the developed countries of the world especially the United States and the United Kingdom- see Titman & Wessels (1988), Rajan & Zingales (1995). The growing importance of capital structure means that it has enabled researchers to make comparisons between countries and institutions all over the world. Rajan & Zingales (1995) examined the determinants of capital structure choice by looking at the financing decisions of public firms in the G-7 countries and discovered that firms among the G-7 countries were fairly levered. Studies on developing economies such as Booth et al (2001) only appeared recently. The Peoples' Republic of China is the largest developing economy in the world and the investment interest it draws from the developed economies makes it an interesting focal point of research.
2.0 RESEARCH OBJECTIVES
This research paper examines the determinants of capital structure in listed companies in the Chinese stock exchange and investigates whether firms in China possesses unique characteristics. It also examines the impact of a change in capital structure on the value of firms listed in the Chinese stock exchange.
3.0 RESEARCH QUESTIONS
This will flow from the research objectives. The researcher will seek to answer the following questions:
(i) Does change in capital structure affect the value of firms listed in the Chinese stock exchange?
(ii) Does tax effect influence the financing decisions of Chinese companies?
(iii) `Do firm specific factors correlated with leverage in developed countries have explanatory power for firms in China?
(i) Does the institutional environment in China have any bearing on a firm's choice of capital structure?
4.0 RESEARCH METHODOLOGY
An extensive and painful review of closely related literature will be undertaken by the researcher to gain adequate knowledge of capital structure theories and how it is applied. This will involve studying text books, journal articles, financial articles and editorials that will enhance knowledge and understanding of the research work undertaken and aid the researcher in answering the research questions.
This research is going to use a sample of the top100 companies listed in the Chinese stock exchange over a ten-year period (1998-2008).The researcher will use data from the annual report of listed companies as well as accounting data of these companies. The main method to be employed is the event study method, where the change in financing mix occurring in these companies within this period will be closely observed.
5.0 TIME SCALE
submit proposals to supervisors
June week 2:
feedback sessions on proposals
June week 4:
Submit comprehensive reading list with abstract
July week 4:
Data collection complete and literature review written
August week 4:
Empirical analysis complete and results written
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The availability of Statistical Package for Social Sciences (SPSS) will aid the researcher in analysing data collected.
7.0 OUTPUT AND DISSEMINATION
The completed research work will be submitted to University of Leeds, Leeds University Business School for the award of an M.Sc in Banking and Finance. After thorough assessment by the school, if successful, the completed work will be submitted to academic journals for onward review and publication. The researcher also plans to use this work as a guide for future research especially in Nigeria where there is dearth of research on capital structure of companies.