Free Corporate Finance In China Essay Sample

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The Capital Structure of Chinese Companies

Introduction
Several researches have been conducted to demonstrate the current structure of the Chinese markets, which appears to significantly vary across various industries (Morri and Beretta 2008). Apparently, in order to understand the intricacies of the capital structure in China, it is important to consider that capital structure is different in each industry. For instance, the property industry is different in the sense that the property industry has more collateral assets accompanied by larger that has higher leverage ratio (Liang, Li and Song 2014). On the other hand, the financial sector sets specific standards when it comes to how firms would finance its operations and assets through a combination of debt, equity, or hybrid securities. These elements will be discussed in the succeeding sections with utmost articulation of the details pertaining to how the Chinese capital structure contributes to the growth of the company.
The discussion will focus on defining what a capital structure is about and what are the financing approaches that firms are available for a firm. The next part of the discussion will analyze the financial system in China and what sort of choices does a China-based company have when it comes to structuring their capital requirements. Furthermore, it is also important to establish the relationship between financial performance and capital structure as it determines whether structured approach in financing is feasible in most of the industries in China. Previous researches provides evidence on the subject of capital structuring in the country in focus, which is imperative in explaining the issues and challenges that firms in China are facing in terms of financing their business. Lastly, the changes in capital structuring will be highlighted in the discussion along with an overview on what determines the Chinese capital structure.

Capital Structure Explained

When it comes to corporate finance, capital structure serves a critical role in ensuring the longevity of the firm’s business operations. It involves financial decisions based on theories, which encompasses the principles of debt and equity (Damodaran 2011). The term was first used in the published work of Modigliani and Miller in 1958, thus the term MM theory was coined (Harris and Raviv 1991). In the MM theory, the capital structure proposition was deemed irrelevant because in a perfect market, capital structure is irrelevant in terms of how a firm finances its operations, thus, the market value of a firm can be determined by the risks in its underlying assets and earning power (Modigliani and Miller 1958). However, the theory presents inadequacies when it comes to the real world applications. This is because the key assumptions in the theory are that there are no taxes, no bankruptcy cost, and no transaction cost.
Consequently, the realities of corporate finance involves transaction cost, taxes, bankruptcy cost, and it cannot be assumed that the borrowing cost is the same for both investors and companies (Harris and Raviv 1991). Therefore, depending on the cost of each aforementioned factor, capital structuring is paramount in ensuring that the financing approach would be able to support the cost requirement of the business operations. There are certain ways companies can source out financing for the business, but debt and equity are the primary types of financing in the capital structure. Debt can be in a form of long-term notes payable or issued bonds. On the other hand, equity can be in a form of retained earnings, preferred stock, or common stock. To put it in a simpler term, capital structure is the firm’s debt to equity ratio, which indicates how risky the company is to invest. If a company appears to have been using long-term debt, therefore, the firm poses a greater risk.

The Financial System in China

China has entered a new era of economic supremacy, as it became the fastest growing and now one the largest economies in the world. The success of the country can be attributed to the influx of investments in the country along. However, the successful outcome of the implemented economic reforms was achieved when the People’s Bank of China handled the credits and savings of the commercial and industrial businesses (Elliott and Yan 2013). It was done by exercising the bank’s functions as a central bank and asserting its legislative power to carry out significant reforms in the country’s financial and banking system. China has formally handled the financial system through its central bank equipped with the authority to supervise, regulate, and control the flow of credit and savings in the majority of state and local banks in the country. Furthermore, the People’s Bank of China ensures the separation of commercial and policy-related finance that compliments the term of functions.

The Relationship Between Capital Structure and Financial Performance

Considering the presented context of the theory of capital structure and the overview of China’s financial system, it can be assumed that financial performance of the firms in the country is correlated with a pre-defined capital structure. The correlation can be perceived by looking at China’s real estate industry where a series of price rocketing and plumping took place. Given the country’s financial system where the government holds the macroeconomic control of the banking system, the relationship between financial performance and capital structure appears to demonstrate an effective financial management approach. On the other hand, previous researches suggest that such relationship does not exist. For instance, Feng and Guo (2015) conducted a study on the relationship between capital structure and financial performance of the real estate sector in China. The results of the study revealed that the coefficient of debt to asset ratio has weak negative correlation after performing a statistical analysis of China’s real estate financial performance (Feng and Guo 2015).
In this regard, the result of the study substantiates the hypothesis of Mondigliani and Miller’s (1958) claim capital structure is irrelevant to the firm’s financial performance. After due consideration of the concepts previously discussed including China’s macroeconomic financial governance, relationship to financial performance, and theory of capital structure, it is apparent that the financial success of the firms in China has something to do with their collective financing approach. This means that there is no pre-defined capital structure that firms in China is using, but instead, every firm is creating their capital structure according to the existing policy conditions, state of economy, and individual financing requirements. However, further determination of the widely used capital structure in Chinese firms can be perceived by analyzing patterns based on previous researches.

Evidence from Research

It was mentioned earlier that capital structure vary according to the type of business or industry. The study conducted by Liu, Ren, and Zhuang (2009) analyzed the capital structure of IT companies in China. A great consideration was given to the size of the company because larger companies normally have more diversified asset index making the cash flow less volatile. With that being said, it is apparent that size can be inversely attributed to the possibilities of bankruptcy. In terms of firms with wider market access, borrowing is a favorable option because of having it with better conditions. Generally, larger firms in the IT industry tend to have a greater proportion of equity than debt because they have less asymmetric information problems and lower leverage (Liu, Ren, and Zhuang 2009). As a result of the empirical study of 92 IT corporations in China, Liu, Ren, and Zhuang (2009) concludes that capital structure and size of the corporation are correlated, but not necessarily significant. This is because IT companies in China are relatively large enough to have higher debt capability and access to bond markets reducing the risk for bankruptcy.
In another study by Tong and Green (2007), the trade-off hypothesis and pecking order were tested to determine the corporate financial behavior of the companies in China. The study encompasses a model developed by Allen, Baskin, and Adedeji (as cited in Tong and Green 2007) in order to determine different predictions. There are several determinants considered to demonstrate evidence on the capital structure of Chinese companies. First is leverage, second is the correlation between dividends and leverage, and lastly corporate investment. The three models were tested for relevance to pecking order and trade-off, but it appears that leverage and profitability has negative correlation as compared to leverage and dividends supporting the claim that pecking order defines the capital structure in China.

Determinants of Capital Structure in China

The remaining question here is what really determines the capital structure of Chinese corporations. In a study by Chen (2003), it was mentioned that neither the Pecking order hypothesis nor the trade-off model derived from the western financial principles could explain the nature of the capital structure of the Chinese firms. The study suggests that Chinese firms follow the contemporary elements of the new Pecking order. The principles under the new Pecking order suggest that the Chinese capital structure is composed of long-term debt, retained profit, and equity (Chen 2003). In the older theories of capital structure, only equity and debt was considered as the important variables that makes up the capital structure, but was deemed irrelevant in terms of financial success.
Apparently, the capital structure of Chinese firms cannot adapt to the Western approach and one of the reasons is institutional difference particularly the financial constraints set by the country’s banking sector and government policies. There are other factors influencing the capital structure of the firms in China, one of which is the leverage decision factor (Chen 2003). To demonstrate the capital structure of China firms, the best example to use for this discussion is the Chinese real estate sector. Since the choice of capital structure is different from every industry, several previous studies suggest that focusing on a specific financial approach can yield a positive outcome. For the real estate sector in particular, the characteristic of its capital structure is unique in the sense that the mast amount of debt is being guaranteed with high valued collateral. According to Bond and Scott (2006), the real estate sector is comparatively safe in terms of their choice of capital structure because the equity performance is associated to the underlying asset held at market value on the balance sheet.
In a nutshell, China’s real estate finance structured is less developed as compared to western economies mainly because the industry itself is still premature in China. The industry source out capital from a stream of cash flow just like any other firms, but as mentioned earlier it didn’t had as much risk because the incurred debt is being compensated with equally valuable collateral. However, once a gap between cash and internal equity occurs, the firm would need to compensate by issuing hybrid securities, debt, or equity. On the other hand, looking into the general nature of the business environment in China reveals that the capital structure is strikingly similar to other developing economies. For instance, the term capital structure refers to a mix of different securities such as preferred stock, long-term debt, convertible debt, commons stock, and the list goes on (Song 2005). However the firm chooses to combine its source of capital the objective remains constant and that is to finance the business’s assets. Despite the similarities between the western economies and China, the fundamental question still remains and that is how the firms in the country chooses the best possible combination in creating a capital structure.
It was mentioned before that firms in China are following the principles of the pecking order theory because the tenets of the theory fits perfectly with the banking policies and requirement of the firms in China. The theory was first suggested by Myers and Majluf in 1984 encompassing an assumption that asymmetric information indicates that the managers are very familiar with the company’s value, prospects, and risks. In this approach the companies in China are trying to time issues when share prices appears to be overpriced or at least priced fairly. The fact that asymmetric information is apparent in the pecking order theory, the investors themselves understand how it works and stock prices tend to fall as soon it was announced. In this regard, the firm choses debt to lower priced external equity for financing.

Challenges and Reforms

Given that China have gained the attention of the international business community and an influx of investment came pouring into country that catapulted its economy to its peak, there are certain challenges arising on how capital structure works for the firm’s advantage. This is because a capital structure model has a significant impact towards the firm’s operational performance. The extent of effect varies, one could be financing risk and the cost of capital while the other implication could be towards the governance structure. In the case of the capital structure in China’s commercial banks, the challenges encountered by the banking sector are more complex than firms in other industries. This is because the principles of the new pecking order theory cannot be applied in the banking sector for various reasons. For one, commercial banks do not have equity capital and at the same time possesses a certain proportion of debt capital. It was mentioned before that a disproportion between the two poses significant risk to the business. In the case of the banking sector, it is more difficult to apply the principles of the pecking order and challenges are at hand considering that the structure in the banking sector is more on the owner’s rights and interests (Zheng 2014). Therefore, the effect of the capital structure that pecking order presents for the Chinese firms vary because not all firms have the same characteristics of capital

Conclusion

The capital structure of companies in China appears to favor the principles of the new pecking order in choosing its mix of financing resources. The other consideration for capital structure is the trade-off theory, but its principles is not compatible with the Chinese firms because of the factors such as prevailing government policies, financial system, and the financing requirement of every firm.

List of References

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Damodaran, A. (2011). Corporate Finance: Capital Structure and Financing Decisions.
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