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Abdullah Shahzad Roll. No. 203BBA 7th (M)
GC University Fsd.
DETERMINANTS OF CAPITAL STRUCTURE: EVIDENCE FROM CHINA
Samuel G.H Huang And frank M. Song
Introduction
(These Slides concepts are According to the Article)
Capital Structure
The question of capital structure has received a lot of attention from economists for quite sometime.
The publication by Modigliani and Miller (1958) is believed to have triggered the beginning of corporate finance as a discipline.
Jensen and Meckling (1976), Miller (1977), Myers (1984), Jensen (1986), Titman and Wessels (1988), Harris and Raviv (1991), among others.
Capital Structure
Financing overall operations and growth using different sources of funds
“Proportion of debt instruments and preferred and common stock on a company’s balance sheet”
Abstract
This paper employs a new database It contains the market and accounting data
from more than 1000 Chinese listed companies up to the year 2000
To document the characteristics of these firms in terms of capital structure.
As in other countries:leverage in Chinese firms increases with firm size, non-debt tax shields and fixed assets.Decreases with profitability and correlates with industries
Hypothesis:
Relationship Between Financial Leverage and Determinants Of Capital Structure
Capital Structure Theories:
Trade off Pecking order Agency cost
Leverage: Ratio of total loans and net total assets
Trade off Theory
Proportion of debt and equity finance to balance cost and benefits Corporate and personal taxes Bankruptcy cost
debt tax liability after tax cash flow
debt Risk of default cost of debt Tradeoff - Optimum capital structure Max value of firm
Trade off Theory
Pecking Theory
Inverse relationship between profitability and debt ratios
Follows Law of Least Effort Firms prefer internal financing
Adopt target dividend payout ratios External Financing
Debt like convertible bonds Equity
Issue costs Internal funds : Least Debt : Low Equity: Highest
Factors affecting leverage
Profitability Size of the firm Non debt tax shield Growth Opportunities Tangibility Dividend Risk Intangibility
Profitability
Trade off theory Positive correlation Increased capacity to bear interest costs Bankruptcy cost of large firm is less More the profit, greater the need for tax
shield Pecking-order theory
Negative correlation Greater profits greater retained earnings
internal funding reduced leverage
Size of the firm
Trade off theory Size of firm & bankruptcy cost – Inverse
relation Positive correlation – size and leverage
Pecking order theory Less information asymmetry for large firm Negative correlation
Non-debt tax shield
If there are other non debt options available for tax shields low leverage
Negative correlation
Growth Opportunities
Trade off theory Strong incentive to avoid under investment Equity can be issued at higher market price Negative correlation
Pecking order Growing firm will not have internal reserves
in abundance Positive correlation
Growth in sales
Tangibility
Trade off Theory Proportion of debt increases with increased
fixed assets Collateralization – Improved guarantee of
repayment Positive correlation
Pecking order Firms with few tangible assets are more
sensitive to informational asymmetries Negative correlation
Tangibility : Ratio of Book value of fixed assets and Total assets of the firm
Risk
Standard deviation of Returns the larger the variations you can expect to see in returns. Increased information asymmetry Shareholders reluctant to invest Resort to debt Positive Correlation
Dividend
Dividend paid / BV of equity Less internal funds Better potential to repay debt External Funding – Debt Positive correlation
Intangibility
Ratio: Intangible assets and total assets Increased information asymmetry Shareholders reluctant to invest Resort to debt Positive correlation
Literature Review
In 1958, First Scientific Research by Modigliani and Miller (MM) proved irrelevance of capital structure on firms value assuming no taxes.
In 1963, MM proved tax shield benefit of leverage leading to increase in value of firm.
In 1977, Scot proposed Tradeoff theory. In 1984, Myers and Majluf proposed
Pecking order theory
Literature Review
In 1995, Rajan & Zingles found positive correlation of tangibility and sales with leverage and negative correlation of market to book ratio and profitability.
In 2003, Drobetz & Fix took six determinants-tangibility, size, market to book ratio, profitability, volatility, uniqueness of products and non-debt tax shield. They found tangibility and size positively correlated and profitability and growth negatively correlated with leverage.
Literature Review
In 2004, Shah & Hijazi studied non-financial firms listed on KSE and took tangibility, size, profitability and growth as determinants.
They found positive impact of tangibility and size and negative impact of profitability and growth In 2007, Shah & Khan studied the no-financial firms
listed on KSE and took six variables-size, profitability, volatility, growth, tangibility and non debt tax shield. They found the only one significant result, negative relationship between profitability and leverage
Research Design
Sample: For 1000 Chinese Listed Companies Population : China Stock Exchange Time: Up To The Year 2000.
Research Design
Data Source: School Of Economics And Finance Center For China Financial Research (CCFR). The University Of Hong Kong Huang’s Email: [email protected] Tel: (852) 2857-8637
Song’s Email: [email protected] Tel: (852) 2857-8507
Model: Regression ModelTell What is Regression Model
Technique: Qualitative Data: Secondary Data(Tell What is Qualitative Data and Secondary Data)
Findings
Variable Correlation with Leverage
Profitability Negative
Volatility in Return Positive
Size of Firm Positive
Tangibility Positive
Growth Positive
Non Debt Tax Shield
Negative
Intangibility Positive
Dividend Positive
Conclusion
Companies with greater profit use internal reserves or raise equity for funding
Investors are less interested for investing in companies with high return volatility
Large firms are favored by creditors due to their less bankruptcy cost
Firms with huge fixed assets can attract more lending due to collaterals
Conclusion Cont…
Companies with high growth perspective find it easy to raise fund through borrowings
Companies with other modes of tax exemption/benefit are less interested in tax benefit on interest paid on debt
Investors are highly sensitive to information asymmetry
High dividend paying firms show more potential to repay debt
THANK YOU
