The Capital Structure of Chinese Companies
Capital structure is considered as a way to determine how a corporation financing its assets by issuing debt or equity. If the firm is entirely financed by the common equity, then it is so called an unlevered firmed, and its whole cash flow belong to its stockholders. If the firm financed both debt and equity, then it is so called a levered firm, and its cash flow will first goes to debt holders and then to stockholders. According to Brealey et al (2010), the total value of a firm is the sum of its debt value and equity value. Nowadays, Chinese listed companies are playing a really important role in the global economy. While the researches on the capital structures of Chinese listed companies are much less than that on western developed firms. In order to have a whole picture of the capital structure in Chinese listed companies, this essay will first briefly introduce some relative theories. For instance, the Modigliani-Miller theorem without and with taxation, trade-off theory and pecking order theory. Also some previous empirical evidences will be given. Secondly, this essay will move to discuss the situation in Chinese listed companies. In this part, it will first list the special characteristics of Chinese listed companies. And then discuss the capital structure of Chinese listed companies by analyzing some related determinants, like profitability, tangibility, non-debt tax shield, size, volubility and ownership structure. In addition, to make the essay more reliable, it will contain two empirical studies’ results, which focus on Chinese listed companies. Finally, this essay will give a brief conclusion to all these findings.
2.1 Modigliani-Miller Theorem without tax (1958)
The modern thinking on capital structure was first started from the Modigliani-Miller theorem (1958) under the assumption of no taxes. In this theorem, it also contains a lot of strict pre-conditions, for instance, there is no transaction costs, bankruptcy costs, agency costs and asymmetric information in the market. The proposition I of the M&M theorem without tax was also called the capital structure irrelevance principle. Because from the theorem, it states that the value of a firm is not relevant with how that firm is financed in a perfect market. In other words, the value of a firm total equity financed should be equal to the value of a firm mix financed: VU = VL
For example, if there are two investors in the market, one buys the shares from the levered firm L, and the other one borrow the same amount money from firm L and use the money purchase the shares from the unlevered firm U. As a result, under the M&M theorem proposition I, the returns to both investors should be the same, and the share price of the levered firm should be equal to the share price of the unlevered firm minus the money borrowed. Moreover, the total value of both firms is also the same, given the required rate of return r. Explain mathematically: V = (E + D) = EBIT/r
Modigliani and Miller’s proposition II states that with more and more borrowing, the risk of equity will be higher, then the shareholders would ask a higher rate of return. Additionally, it also claims that the expected return on equity is a linear function of that firm’s debt to equity ration: rE = rA+(rA-rD)D/E
Under the proposition II, if the capital structure is irrelevant to the firm’s value, the WACC would contains the same, although the expected rate of return keep rising as the increasing debt ratio. Shows graphly:
To conclude, M&M proposition I states that the firm’s value cannot be maximized by adjusting its capital structure, and the proposition II claims that the WACC cannot be minimized by adjusting capital structure. The capital structure is irrelevant with the firm’ value in the perfect market. 2.2 Modigliani and Miller Theorem with tax 1963
In 1963, Modigliani and Miller introduced corporate tax...
References: Asquith, P. & Mullins, D.W. (1986), ‘Equity Issues and Offering Dilution’, Journal of Financial Economics 15-2, 61-89.
Berger, G. P., Ofek, E. and Yermack, D.L. (1997), ‘Managerial entrenchment and capital structure decisions’, Journal of Finance 52, 1411-1438.
Brealey, R.A., Myers, B., Franklin, A. (2010), Principles of corporate finance, McGraw-Hill/Irwin.
Booth, L., Aivazian, V., Demirguc-Kunt, A
Chen, J. & Strange, R. (2005), ‘The Determinants of Capital Structure: Evidence from Chinese Listed Companies’, Economic Change and Restructuring, 38-1, 1-35.
Copeland, T. and Weston, F. (1992), Theory of Finance and Corporate Policy, 3rd edn, Reading, MA, Addison-Wesley.
Frank, M. and Goyal, V. (2003), ‘Testing the pecking order theory of capital Structure’, Journal of Financial Economics 67, 217–248.
Friend, Irwin, and Larry H.P. Lang, (1988), ‘An empirical test of the impact of managerial self-interest on corporate capital structure’, Journal of Finance 43, 271-281.
Harris, M. and Raviv, A. (1990), ‘Capital structure and the information role of debt’, Journal of Finance 46, 321–345.
Helwege, J. and Liang, N. (1996), ‘Is there a pecking order? Evidence from a panel of IPO firms’, Journal of Financial Economics 40, 429–58.
Hsia, C. C. (1981), ‘Coherence of the modern theories of finance’, Financial Review, 27-42.
Huang, G.H. and Song, F.M. (2006), ‘The determinants of capital structure: Evidence from China’, China Economic Review 17 (1), 14-36.
Jensen, M. (1986), ‘Agency costs of free cash flow, corporate finance, takeovers’, American Economic Review 76, 323–329.
Jensen, M. & Meckling, W. (1976). ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’. Journal of Financial Economics 3, 305-60.
Marsh, P. (1982), ‘The choice between equity and debt: An empirical study’, Journal of Finance 37, 121-144.
Modigliani, F. and Miller, M. (1958), ‘The cost of capital, corporation finance, and the theory of investment’, American Economic Review 48, 261–297.
Modigliani, F. and Miller, M. (1963), ‘Corporate income taxes and the cost of capital: a correction’, American Economic Review 53, 433–443.
Myers, S. and Majluf, N. (1984), ‘Corporate financing and investment decisions when firms have information that investors do not have’, Journal of Financial Economics 13, 187–221.
Rajan, R. and Zingales, L. (1995), ‘What do we know about capital structure choice? Some evidence from international data’, Journal of Finance 50, 1421–1460.
Titman, S. and Wessels, R. (1988), ‘The determinants of capital structure choice’, Journal of Finance, 43, 1-19.
Wang, J. & Yang, F.L. (2002), ‘The Empirical Research of Money-Raising Structure of Listed Companies’, Economic Theory and Management 6, 23-28.
Please join StudyMode to read the full document