Pecking Order or Trade-Off Hypothesis? – Evidence on the Capital Structure of Chinese Companies

Introduction
Finance Theory offers 2 broad competing models → determine the capital structure of firm → Trade-off theory and pecking theory order
Trade-off theory states → value-maximizing firm will pursue an optimal capital structure by considering the marginal costs and benefits of each additional unit of financing → equates these marginal cost and benefits
Benefits of debt → tax advantage, reduced agency cost of FCF
Cost of Debt → increased risk, increased monitoring, and contracting cost associated with higher debt levels
The pecking order hypothesis argue → asymmetric information creates a hierarchy of cost in the is of external financing which is broadly common to all firms
New investment are financed first by retention → then by low-risk debt followed by hybrids like convertibles. → equities only as the last resort
Trade-off → large equity issues of low-leverage firms → better
Pecking order → the negative impact of profitability on leverage → better
Reason might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts
First → many private firms in the DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage → corporate strategy is a significant determinant of capital structure → basic goals of the company
Second → Capital markets are less developed in the DTEs → it is typically a narrower rage of financial instruments available and a wider range of financial countries
Finally → accounting an auditing standards in DTEs tend to be relatively lax
Singh & Hamid → Firms in developing economies rely more heavily on equity than n debt to finance growth than do their counterparts in the industrial economies
Difficulties in distinguishing between trade-off and pecking order → because many determining variables are relevant in both models
This paper → studies the determinant of capital structure decisions → of Chinese companies → China is of interest for several reason → but particularly → because it is in unique position of being both → developing economy and transition economy
Huang and Song (2002) find → correlation between leverage and these characteristics in Chinese state-controlled listed companies → surprisingly similar to what have been found in another country
Huang and Song also → static trade-off model explains the capital structure of Chinese listed companies better than the pecking order hypothesis
Hypotheses
→ Fama and French (2002) emphasize → many of the variables held to determine leverage under trade-off or pecking order theories are common to both theories
→ in present test → three related aspects of corporate financing where trade-off and pecking order theories give different predictions are examined:
Determinants of Leverage → profitability, size, growth
Since less profitable firms → provide low shareholders return → greater leverage → increase bankruptcy risk and cost of borrowing → will lower shareholder returns still further
Low shareholders returns will also limit equity issues → therefore → unprofitable firms facing a positive NPV investment opportunity → will avoid external finance in general and leverage in particular
Thus Trade-off theory predicts a positive relationships between leverage and profitability
Baskin (1989) regresses current leverage on current profitability → will necessarily result in a decrease in current debt given investment and dividends
The study also controls → firm size → help discriminate between trade-off and pecking order theories
Warner (1977) argues → that there are economies of scale in bankruptcy → implying that the agency cost of debt → will be lower for larger companies
The converse argument is that firm size is a proxy for information asymmetries between the firm and the market
Larger the firms → more complex its organization → higher cost of asymmetries → and more difficult to raise external finance
Leverage and Dividends
Pecking order theory does not provide a distinctive theory of dividend → but the theory can be combined with the Lintner dividend model (1956) → to generate predictions for the impact of dividend on leverage
Pecking order theory implies → firms with higher past dividends → will have less “financial Slack” → and therefore higher leverage → because they require more external funds
Baskin (1989) → a significant positive relationship between the past dividend rate an current leverage supports the pecking order hypothesis
Pecking Order or Trade-off Hypothesis
Asymmetric information may cause rejection of profitable investment opportunities → because of the cost associated with rising external finance
Unlike trade-off theory → this implies the existence of direct links between asset growth and financing
The asymmetric information which lies behind pecking-order theory implies → larger firms are less transparent than smaller firms
Data and Methodology
China is in transition form a planned economy to → market economy and continuous to be characterized by a fragmented capital market, fragile banking systems, poorly specified property rights and institutional uncertainty
Most listed companies were originally state-owned enterprises, and privatizations has been incomplete → because the state often retaining a controlling share
Firms could partially disclose, distort, and even forge information for transaction or taxation purposes → with low risk of being caught
China’s accounting system is now being gradually harmonized with international Financial Reporting Standards (IFRS)
January 1st 2001 → new Accounting System for Business Enterprise implemented → All listed companies were requires to follow a enforcement procedures → but for smaller companies remain problematic
Data Covering China’s top 50 listed companies for the period 2001-2003 → the listings based on total assets, income from main business, net profit, and market value
Moreover → the study checked for the robustness of the underlying models by carrying out cross-equation test for parameter equity as between the two years of the estimated model
Two measures of leverage
First → wide measure → the ratio of total liabilities to total assets → commonly used in leverage studies → this suggest that trade credit given should be deducted from total assets
Second leverage measures → account receivable are deducted from total assets
Two other variables → defined in standard ways
First → measuring profitability (ROA) → one should ideally use the ratio of operating income to operating assets → rather than total assets
Second → dividend are scaled by book equity rather than the market value
Chinese share price were very volatile in this period and use of the dividend yield would have created distortions in the dividend measure in the cross-section
It is difficult to compare → Chinese with other countries → because of the substantial variations in the applications of accounting standards in China
Results
In general→ model 1 performs well as it mostly explains more than 50% of the cross-sectional variation in leverage
Profitability mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression → when larger profitability is entered on its own → negative and significant → robust support for pecking order theory
The performance of Interaction between investment and financing → rather less satisfactory
Dividends and size → negative but not significant → consistent with pecking order theory → on the other hand → positive sign on leverage are more consistent with → trade-off theory
Finally → results of parameter stability test → emphasized that there are severe test because of the accounting changes between 2002 and 2003 → the results show that there is some degree of stability in the parameter across time periods
Conclusion
This study aims → Shed light on the empirical debate between the trades-offs and pecking order theories in → Chinese companies.
Main findings:
First → Significant negative correlation between → leverage and profitability
Second → Significant positive correlation between → current leverage and past dividends → although at lower significant level
Third → Investment model is inconclusive since → an insignificant negative correlation between → growth of investment and the rate of past dividends
Fourth → There is some degree of stability in the parameter values
The Most important finding
→ Surprisingly simple and conventional model as capable of explaining a significant proportion of → cross-sectional variation in → leverage among Chinese companies
Overall → results provide → tentative support for the pecking order hypothesis → demonstrate that a conventional model of corporate capital structure → can explain the financing behavior of Chinese companies