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

I. Introduction
a. Determine capital structure of a firm
i. Trade-off theory
§ A value-maximizing firm will pursue an optimal capital structure by considering → the marginal cost and benefits of each additional unit of financing → then choosing the form of financing that equates these marginal cost and benefits
o Benefits of debts → include its tax advantage and the reduced agency costs of FCF
o Cost → include the increase of risk of financial distress and increased monitoring and contracting costs associated with higher debt levels
ii. Pecking order theory
§ Based on the argument → asymmetric information creates a hierarchy of cost in the use of external financing which is broadly common to all firm
b. Distinguish the two theory in practice is not easy
i. Fama and French can only identify two predictions on which either theory performed better than another
§ Trade-off theory → better in “large equity issues of low leverage firms”
§ Pecking order theory → better in “the negative impact of profitability on leverage”
c. It is difficult to distinguish between trade-off and pecking order models because many determining variables are relevant in both models
d. Several reasons why one might expect firms in developing and transition economies (DTEs) to have different financing objectives from their counterparts in the industrial countries
i. Many private firms in DTEs were originally state enterprises and carry different goals and corporate strategies from this heritage
ii. Capital markets are less developed in DTEs → narrower range of financial instruments → wider range of constraints on financing decision
iii. Accounting and auditing standard in DTEs tend to be relatively lax → implementing asymmetric information is more problematic
e. Singh and Hamid (1992) and Singh (1995) → concluded that firms in developing economies rely more heavily on equity than on debt to finance growth than do their counterparts in the industrial economies
f. None of the researchers explicitly set out to discriminate between trade-off and pecking order theories in a manner designed to discriminate between them
g. This paper studies the determinants of capital structure decisions in a sample of listed Chinese companies
i. China is of interest for several reasons → but particularly because it is in the almost unique position of being both a developing economy and a transition economy

II. Hypotheses
Three related aspects of corporate financing where trade-off and pecking order theories give different predictions:
a. Determinants of Leverage: profitability, size, and growth
i. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relationship between leverages and profitability
o Unprofitable firms facing a positive NPV investment opportunity will avoid external finance in general and leverage in particular
§ Pecking orders theory → there will be negative relationships between leverage and profitability
o Firms will use retentions first then debt and equity issues as a last resort
o Less profitable firms facing a positive NPV investment opportunity will be more willing to use external funds if cash flow are weak
ii. Trade-off theory and Pecking order theory
§ Trade-off theory → a positive relation between leverage and firm size
o There are economic scale of bankruptcy → agency cost will be lower for larger company
§ Pecking order theory → a negative relation between leverage and size
o Larger the firm → more complex the organization →higher the cost of information asymmetries → more difficult to raise external finance

b. Leverage and Dividends
i. Trade-off theory → negative relationship between dividends and leverage
§ Dividend are high (retention low) → because external financing low
ii. Pecking order theory → Positive relationship between dividends and leverage
§ Firms with higher past dividends will have less financial slack → higher leverage → because they require more external funds

c. Corporate investment and financing
i. Trade-off theory → Leverage should be negatively related to investment → because of funding limitations arising from high leverage
ii. Pecking order theory → larger firms are less transparent than smaller firms

III. Data and Methodology
a. Use base in China
i. China → in transition from a planned economy to a market economy → continues to be characterized by a fragmented capital market, fragile banking system, poorly specified property rights and institutional uncertainty
ii. Chinese firms → have a relatively short operating history → have not accumulated much reputation
iii. Most listed companies→ originally state-owned enterprises → privatization has been incomplete with the state often retaining a controlling share
iv. Banks → often process commercial loans and collect debts in a preferential way → the market is subject to irregular government intervention
v. A well-functioning and fully-enforced accounting and auditing system has developed only gradually in China
vi. Firms could partially disclose, distort, and even forge information for transaction or taxation purposes with low risk of being caught
b. Study attention and methodology
i. China top 50 companies for the period 2001-2003 → data were extracted from the published accounts of non-financial companies listed on the Shanghai and Shenzhen stock exchange
ii. The listing is based on total assets, income from main businesses, net profit and market value
iii. For holding companies → the consolidated data were used
iv. Two datasets:
§ For 2002 and 2001 → using 2002 annual report
§ For 2003 and 2002 → using 2003 annual report
v. Two measure of leverage
§ Wide measure → ratio of total liabilities to total assets
§ Standard ways → two comments:
o In measuring ROA → one should ideally use the ratio of operating income to operating assets rather than total assets
o Dividend → scaled by book equity rather than the market value

IV. Results
a. More than 50% of the cross sectional variation in leverage
b. Profitability → mostly has a negative and generally significant coefficient irrespective of whether it is lagged in the regression →provide quite robust support for pecking order theory
c. Assets growth → highly significant and has a positive sign contrary to the predictions of trade-off theory
d. Size → signed positive, a finding that is more consistent with trade-off theory
e. Dividend → positively signed as predicted by pecking order theory
f. Dividend and size → signed negative but not significant → consistent with pecking order theory
g. Profitability:
i. Negative but significant in 2002 → consistent with trade-off theory
ii. Positive but significant in 2003 → consistent with pecking order theory
h. There is some degree of stability in the parameters across time periods