Dynamic Capital Structure in China Determinants and Adjustment Speed

Question: How Dynamic capital structure in china determinants and adjustment speed? Answer: Introduction Capital Structure refers to the optimal use of various monetary sources of a company to finance its operations. It has two components namely, debt and equity. Debt (Both short term and long term) is associated with long term notes payable, issuance of bonds etc. while equity is associated with stocks (common or preferred), retained earnings etc. Optimal allocation of financial sources subject to these two constraints is the major motto of Capital Structure. The main objective of this paper is to address different determinants of capital structure by clubbing them under a set of company-specific variables like non-debt tax shield, profitability, growth, liquidity, dividend, and firm size. The relationship of these firm-specific variables and their effect on capital structure decisions will be examined under a basic simple model. According to the research papers of Qian et al., 2009; DeAngelo et al., 2011 and Ebrahim et al., 2014, most of the companies adjust their debt leverage towards a targeted leverage score. This implies that companies frame their strategies towards capital structure and perform deviations from the debt leverage target only after adjusting the debt-equity ratio instantaneously. As these decisions have crucial impact on firms cost of capital, investment decisions, valuation and expected returns, this paper explains the rationale behind these decisions by investigating various determinants of capital structure. Literture Review The dependent variable of our study is capital structure. Various studies use various proxies for capital structure. Some argues that debt leverage is a good measure (Debt leverage is calculated as book total debt to book total assets) whereas some suggests book value is an efficient function for investigating firms financial behavior because of its marvelous explanation of assets with price stability. Moreover, managers prefer book value to make financial decisions because it is very expensive for companies to adjust the assets value responding to market condition (Myers, 1997 and Graham Harvey, 2001). According to Guney et al. (2011) and Ebrahim et al. (2014), the adjustment speed was found to be 36% and 28% for Chinese and Malaysian firms respectively by using lagged debt leverage. Now we move forward to explain the rationale for using different variables in our analysis as per the existing literature. Determinants of capital structure: - The explanatory variables under this study are the companys financial indicators. We have incorporated the most common factors under some broad classifications like non-debt tax shield, profitability, growth, liquidity, dividend, and firm size. These variables are very common in both developed and developing countries. Profitability: - According to the pecking order theory, companies prefer internal funds than external financial source (Myers, 1984). According to the Agency theory, highly profitable companies strive to raise more debt for reduction of agency cost due to the misuse of free cash flow by the managers of the firm (Jensen, 1986). Baskin (1989) suggests that past profits have important effect on current debt leverage. In our paper, we use the companys earnings before interest and tax as a measure of current profitability to investigate the companys capital structure decision. Firm size: - The existing literature reveals that the large firms having more stable profitability and flow of cash are associated with lower risk of bankruptcy and hence are authorized to raise higher debt from external financial sources (Fama and French, 2005; Frank and Goyal, 2009). On the other hand, Titman and Wessels (1988) suggests the inverse relation of the firm size to debt leverage since large firms are in a better position to issue equity than the small firms. Firm size is one of the traditional variables in the literature on capital structure and is measured by logarithm of total book assets. Non-debt tax shield: - According to the Trade-off theory, companies tend to obtain more debt when they benefit from higher tax shield. This gives an inverse relationship between debt leverage and non-debt tax shield (DeAngelo and Masulis, 1980). Non-debt tax shield is also a traditional variable analyzed in capital structure studies and it is measured by the sum of depreciation and amortization to total assets. Growth: - As per the papers by Myers and Majluf, 1984 and Frank and Goyal, 2009, debt leverage and growth are inversely related as companies possess easy access to equity funding when they have higher market growth opportunities. On the other hand, Guney et al. (2011) suggests that there is a positive impact of growth on debt decision. Shyam-Sunder and Myers (1999) argues that the change of book assets have significant impact on capital structure decision because of its direct impact on financial deficit. In this paper, we examine firm size by both market growth opportunity and book asset growth. Dividend: - According to Chen et al. (2009), there exist a positive relationship between debt leverage and dividend for the Chinese companies as they deliberately channel their profits to the shareholders through dividends. On the other hand According to Jensen et al. (1992), the effect of dividend is ambiguous i.e. it can be either positive or negative because companies take their dividend decisions by trading off constant financial charges. In our paper, we use dividend per share study to compute its effect on debt leverage. Liquidity: - According to Leary and Roberts (2010), certain companies tend to reserve their debt capacity either for future investment, or to counter the negative impact of underinvestment problems that arises due to high debt leverage. On the other hand, Guney et al. (2011) suggests that higher collateral predicts higher debt for Chinese firms because higher liquidity computed by current ratio shows lower debt whereas Agency cost theory argues that companies raise debt so as to reduce free cash flow by paying interest (Jensen, 1986).With a view to these distinct findings, the variables like current ratio, cash and marketable securities and cash from operation are used to calculate the impact of liquidity. Moreover, we also use quick ratio to observe collateral function in liquidity since quick ratio is nothing but current ratio obtained by excluding inventories. Various papers also focus on the macroeconomic policies and condition for financial behavior of the companies because of the fact that greater interest tax shields for firms (Frank Goyal, 2009 and Fan et al., 2012). According to Mokhova and Zinecker (2014), government debt to GDP has significant effect on capital structure. Several research journals also emphasize on the human resource factors while studying for capital structure. According to Grossman and Hart (1982), discussing the possibility of bankruptcy motivates the managers to increase their potential output. On the other hand, Kale et al. (2007) suggest that debt serves as a tool for bonding mechanism and is positively correlated with employee productivity as employees try to hedge the risk of job loss when the firm possesses high debt by maintaining higher productivity. This paper also argues that the magnitude of relationship between debt leverage and employee productivity is negatively influenced by external employment o pportunities. Thus, the role of debt is weakened when external employment opportunities are increased. Hypotheses development While examining the dependency of capital structure decision of various firms on various financial factors, we have to test the following hypotheses: H (1): Profitability has significant effects on capital structure decision. H (2): Firm size has significant effect on capital structure decision. H (3): Dividend has significant effect on capital structure decision. H (4): Liquidity has significant effect on capital structure decision. H (5): Growth has significant effect on capital structure decision. Testing these hypotheses will give us the understanding of the impact of these financial variables on our capital structure decisions. Research Methodology As reported by the literature review section, the capital structure decision is expected to be driven by the mentioned firm-specific financial factors. In our analysis we consider a simple OLS regression model for testing the hypotheses. For examining the firm-specific factors the equation is written as: Yit* = i + iXij + ui. (1) Here Yi represents the capital structure of the ith firm in tth year. X gives the vector of explanatory variables. The error term is represented by ui. The vector of explanatory variables, X, includes the following: - (1) EBIT, (2) firm size, (3) cash and marketable securities, (4) assets growth, (5) cash from operation, (6) dividend per share, (7) non-debt tax shield, (8) current ratio, (9) quick ratio, (10) growth opportunities. Descriptive statistics: - Table 1 gives the descriptive statistic of all the variables used in our analysis. The mean debt ratio is found to be 22.97% which states that these firms are less levered compared to companies of other developing countries and some developed countries. Variables Mean Standard Error Median Standard Deviation Sample Variance Kurtosis Skewness Range Minimum Maximum Sum Confidence Level(95.0%) Capital Structure 22.97377 1.262704 16.22877 0 20.82505 433.6825 3.429573 1.51394 141.6274 0 6248.864 2.485956143 EBIT 123410.2 27571.69 26396.5 0 454724 2.07E+11 10.76952 0.213199 4508967 -2294529 33567563 54281.94674 Book asset growth 33.03554 27.59178 1.45304 -100 455.0553 207075.3 262.3011 16.06343 7543.481 -100 8985.666 54.32148877 Market growth opportunity 7436.197 1270.255 954.7148 0 20949.58 4.39E+08 23.05907 4.506833 187070 -51423 2022646 2500.821946 Dividend per share 1.827893 0.620561 0 0 10.23455 104.746 79.29406 8.439262 110 0 497.187 1.221732538 Current ratio 524.2044 319.2929 0.125 0 5265.913 27729844 123.9754 10.87616 67823 0 142583.6 628.6098921 Quick ratio 0.630882 0.050026 0.195 0 0.825043 0.680696 3.013667 1.600359 4.28 0 171.6 0.098488169 Cash and Marketable securities 168831.9 18610.03 44941.5 0 306924.4 9.42E+10 20.76774 3.819782 2688644 0 45922264 36638.60935 Book total Debt 22.97377 1.262704 16.22877 0 20.82505 433.6825 3.429573 1.51394 141.6274 0 6248.864 2.485956143 Fim size 13.92436 0.133729 14.21559 0 2.205521 4.864324 15.54624 -2.82974 16.77148 0 3787.425 0.263280518 Non-debt tax shield 1.419533 0.111741 0.560943 0 1.842882 3.396214 3.344908 1.85759 8.794716 0 386.1129 0.219991048 Correlation matrix Correlation coefficient of all variables are examined in the study and presented in matrix form in the table 2 given below. It is observed that the correlation coefficients between the explanatory variables and capital structure are generally consistent. Capital Structure EBIT Book asset growth Market growth opportunity Dividend per share Current ratio Quick ratio Cash and Marketable securities Book total Debt Fim size Non-debt tax shield Capital Structure 1 -0.04439 -0.05752 0.280519 -0.17302 -0.03475 -0.18953 0.013309 1 0.257524 -0.14687 EBIT -0.04439 1 -0.0041 0.003335 -0.02881 0.003744 0.166344 0.26799 -0.04439 0.228438 -0.03596 Book asset growth -0.05752 -0.0041 1 -0.02115 -0.01579 -0.01082 -0.05236 -0.03733 -0.05752 -0.07473 -0.03106 Market growth opportunity 0.280519 0.003335 -0.02115 1 -0.06143 -0.03453 -0.03539 -0.07641 0.280519 -0.05595 -0.08401 Dividend per share -0.17302 -0.02881 -0.01579 -0.06143 1 -0.01194 0.33683 -0.09368 -0.17302 -0.24722 0.045613 Current ratio -0.03475 0.003744 -0.01082 -0.03453 -0.01194 1 0.090305 -0.03754 -0.03475 0.002733 0.051975 Quick ratio -0.18953 0.166344 -0.05236 -0.03539 0.33683 0.090305 1 0.110134 -0.18953 0.128627 0.409857 Cash and Marketable securities 0.013309 0.26799 -0.03733 -0.07641 -0.09368 -0.03754 0.110134 1 0.013309 0.404355 -0.06397 Book total Debt 1 -0.04439 -0.05752 0.280519 -0.17302 -0.03475 -0.18953 0.013309 1 0.257524 -0.14687 Fim size 0.257524 0.228438 -0.07473 -0.05595 -0.24722 0.002733 0.128627 0.404355 0.257524 1 -0.16438 Non-debt tax shield -0.14687 -0.03596 -0.03106 -0.08401 0.045613 0.051975 0.409857 -0.06397 -0.14687 -0.16438 1 Regression Result According to our analysis, we can say that the variables that are statistically significant are EBIT, Firm size, current ratio and book total debt. Statistical significance of the variable EBIT implies that a companys profitability is the most important determinant of its capital structure while statistical significance of the variable Firm size refers to the fact that bigger firms tends to have greater debt. Current ratio is observed to have negative statistically significant coefficients while cash and marketable securities possess statistically insignificant and negative coefficients. This result is in line with that of Guney et al. (2011) who claimed that liquidity represented by current ratio has negative impact on capital structure. Conclusion In this paper, we try to examine certain firm-specific financial variables which can significantly explain the capital structure of the companies under study. The analysis is based on a simple OLS regression model for testing the hypotheses explained earlier. Firstly, we aim to identify the prime determinants of capital structure. 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