Predictions

Profitability. Return on assets is going to be used as the measure for this factor. The two theories presented above have opposite predictions regarding this variable.

According to the trade-off theory, as companies become more profitable, they are going to want to borrow more money in order to shield them from tax. In addition, higher profitability results in higher free cash flows and increasing the leverage could help to keep a grasp on the management and tackle the agency costs (Jensen, 1986). However, the prediction of trade-off theory does not seem to be correct in majority of studi11es and a new dynamic trade-off model predicts negative relationship of profitability and leverage (Strebulaev, 2007).

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The pecking-order theory predicts that profitability has negative influence on the leverage, as with increased profitability the firm is going to have more internal funds to spend on its investments.

As can be seen in Table 1 almost all of the previous researches on capital structure of Chinese companies report negative relationship between the two attributes, and often a lot more significantly than in other countries. This is because of the difficulties that

Table 1 Comparison of results in selected studies focusing on China.

Source: The table was modified from (Chang et al., 2014).

Ps. (+) and (-) indicate positive and negative relationship, no sign means there is no significant relationship.

Profitability Assets

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Chinese listed companies face when trying to raise external funds, whether it is in the form of debt or equity, making the retained earnings much more important to the firms in China than to those in the United States. Furthermore, the China Securities Regulatory Commission requires companies to be highly profitable for a period of time before being able to issue new equity, causing profitability to have even more negative influence on the leverage (Chang et al., 2014).

Assets tangibility. Asset tangibility increases company’s credibility, because the tangible portion of assets can be used as a collateral by the lender and as a result reduce his risk. Also in case of bankruptcy, tangible assets are easier to value and liquidate than intangible assets, effectively reducing the bankruptcy costs (Jensen & Meckling, 1976).

According to the trade-off theory this should have positive effect on the leverage, as the balance between tax reduction and financial distress is moved higher.

Under the assumptions of pecking-order theory, the prediction is opposite, as higher assets tangibility reduces the information asymmetry and makes issuance of new equity cheaper and debt less preferable.

Although some researches regarding non-listed companies get results showing negative relation between the variables (Li et al., 2009), majority of previous researches focusing on listed companies in China show positive relationship, as can be seen in Table 1 .

Firm size. Firm size influences the capital structure of companies in several ways. First of all, bigger firms usually have considerably lower risk of bankruptcy and higher

resistance to market volatility. In addition, bigger firms are often able to access outside funding at lower costs than their smaller competitors and are overall more likely to

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diversify the sources of their financing. According to the trade-off theory, these points should result in positive relationship between firm size and leverage. On the other hand, it is believed that small and large firms have different levels of information asymmetry, as the larger firms have usually been around for longer time and are better known, and sometimes are subject to higher scrutiny (Kurshev & Strebulaev, 2007). Because of that, the pecking-order theory suggests negative relationship between the variables, as firms can access equity cheaper.

Previous researches in China and other countries are generally consistent and report firm size to be positively related to firm’s leverage.

Assets growth. Asset growth is a proxy variable for growth opportunities. It is not as popular as market to book asset ratio proxy, but because of the frequent mispricing existent in the Chinese stock markets, it does appear to be a better variable in China (Chang et al., 2014). Firms with higher growth opportunity often face bigger financial distress and less of free cash-flow problem. Following the trade-off theory this should move the target leverage to lower levels, as the company should want to reduce the distress and does not need to worry about agency costs as much. However, in the years before the financial crisis of 2008, many of Chinese listed companies having a

considerable amount of shares in possession of government were enjoying borrowing privileges from Chinese banks (Qian et al., 2009). In addition, because of equity issuing restrictions specific to China, companies with growth opportunities might be forced to use debt in higher levels, as they are not able to raise enough financing through retained profits and equity (Chang et al., 2014). This means that growth opportunities might have much lower influence on leverage in China than in other countries.

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The pecking-order theory suggests positive influence of growth opportunities on leverage, as retained earnings and debt should be the prime source for financing company’s investments. However, this assumes that profitability of the firm is held at constant level (Frank & Goyal, 2008). As shown in Table 1, previous researches in Chinese market returned inconsistent results regarding the influence between growth

opportunity and leverage.

Industry median leverage. There is no doubt that the level of leverage across

different industries varies and the industry median leverage has been found to be one of the most important determinants of companies’ financial leverage in many researches (Bowen, Daley, & Huber, 1982; Lemmon, Roberts, & Zender, 2008; MacKay & Phillips, 2005). In the studies focusing on China, only Li et al. (2009) and Chang et al. (2014) included the variable, although in their results the significance was a little lower than for example in Frank & Goyal (2009) research on US firms, where it was explaining the most variance of the factors included, both of them still found it to be one of the most

important factors in predicting the capital structure.

State control dummy. State control dummy is a variable that is almost exclusive to Chinese market. Papers researching capital structure and the factors influencing it in US, developed and developing countries do not include it, because in most of the countries state controlled enterprises either do not exist or account for a fraction of the markets.

In China, although the percent of state owned enterprises (SOEs) is decreasing, the change is very slow and SOEs still constitute a major part of the market and are present in virtually every industry. SOEs enjoy some benefits not available for private enterprises, as many financial institutions are also state controlled and allow for lending of money to

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SOEs on privileged conditions and financial help in case of distress, suggesting that these companies should have higher level of leverage. On the contrast, because of unfair treatment they also might find it easier than privately owned enterprises to raise equity, which could result in negative influence on the leverage.

For the reasons mentioned above, state control is included in almost every research focusing on capital structure of Chinese companies, but the results are rather

inconsistent. Li et al. (2009) and Qian et al. (2009) found that a positive relationship between state ownership and leverage exists. Huang & Song (2006); Zou & Xiao (2006) and Bhabra et al. (2008) find state ownership to be neutral on leverage, while Chang et al. (2014) and Firth, Lin, & Wong (2008) even found negative relationship between the two.

Largest shareholding. The percentage of total company shares held by the top shareholder. This variable similarly to state control dummy is rather specific for China.

The weak rights of investors in Chinese market and the sparingly effective law

enforcement induces the controlling shareholders to thinking that as long as they keep the control, new equity is a form of financing that does not bind them to anything. That would suggest that they might prefer equity to debt. The higher the percentage of shares held by the largest shareholder, the lower the risk that he loses control during dilution, so if the above assumptions are correct, then the largest shareholding should be negatively related with leverage. The variable was included and found to have significantly negative relationship by Chang et al. (2014).

Macroeconomic factors. Many different macroeconomic factors have been included in previous researches, but other than inflation being a reliable determinant in the USA

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(Frank & Goyal, 2009), all of them seem to be unimportant when determining the capital structure of company. Chang et al. (2014) used three macroeconomic variables in his research focusing on China: inflation, GDP growth and the growth rate of overall after-tax profits of industrial firms, but found all of them to be insignificant. In this research I am going to include five macroeconomic factors that have not been used in previous papers and check for their importance.

First one of them is the amount of Quarterly Exports in whole China. Many argue that the economic growth in China in the past few decades was highly driven by foreign trade, thus the export could be a good indicator of economic developments (Cui, 2007). A bigger than usual increase in exports might be signaling growing demand and growth opportunities, driving companies to quickly borrow more money in order to finance new investments and get the most of this opportunity. On the other hand, if exports decrease it is likely that global economy is slowing down and the demand is decreasing, so

companies might want to resign from some riskier investments and reduce the debt.

That suggests that the growth in quarterly exports should be positively related with financial leverage.

Another factor is the Foreign Direct Investment (FDI). There have been many researches done that found FDI-export linkage to exist, and it seems to be particularly major in China (Zhang, 2015). A big part of Chinese exports constitutes of exports by companies that were created by foreign investments, but the FDI also has positive effect on the exports of domestic companies. The foreign companies are usually more

experienced at exporting, but because the domestic companies can mimic their behavior, their presence reduces the export costs for local companies in the same industries, making exporting more attractive and increasing its volume (Sun, 2012). For

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these reasons, if a correlation between FDI and the level of financial leverage used by Chinese companies exists, it is likely to have a positive relation.

Next factor is Domestic Retails Sales of Consumer Goods (DRSoCG). The variable similarly to Quarterly Exports can be considered an indicator of the demand levels, but a few important differences between the two exist. First of all, as the name suggests DRSoCG takes into account only sales within China. Furthermore, it only includes non-production and non-business physical commodity sold to individuals and social

institutions, and revenue from providing catering services. Individuals include rural and urban households, population from abroad, while social institutions include government agencies, social organizations, military units, schools, institutions, neighborhood (village) committees. Predictions are then the same as in case of Quarterly Exports, of positive relationship between DRSoCG and leverage, but this variable will show if companies adjust their capital structure in reaction to domestic demand changes.

The fourth of the macroeconomic factors included is money supply. This variable could be considered a proxy variable for inflation. Usually when money supply grows or shrinks, the prices react in the same way. According to the trade-off theory, if money supply grows companies should want to borrow more money, as the tax-shielding is higher when inflation levels are high (Robert A. Taggart, 1985). On the other hand, when money supply is increased for example due to quantitative easing implementation by government, the money is often pumped into stocks, increasing the market value of companies’ shares and making it more attractive for them to issue new equity, which in turn would lower the financial leverage levels within them.

And the last variable included is manufacturing Purchasing Managers’ Index (PMI).

The PMI level is based on a survey of purchasing managers within manufacturing

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companies, whom are asked questions about the companies’ outlook compared to previous years. The fields they are asked about are production level, new orders from customers, speed of supplier deliveries, inventories, order backlogs and employment level. This is also an indicator that might suggest growing or declining demand and increasing or decreasing growth opportunities for companies, but coming from within the manufactures, rather than their customers. It might be based on some data and knowledge that is available to the managers, but not openly available to the people from outside of the company and it also might include some predictions of the future, rather than being based purely on the past data like Quarterly Exports and DRSoCG. Although also predicted to have positive relationship with the financial leverage, for the reasons above it is likely to have different level of significance than Quarterly Exports or DRSoCG.

Profitability Assets

tangibility Firm size Growth opportunities (Chen, 2004) Pecking-order Trade-off Trade-off Pecking-order (Tong & Green,

2005) Pecking-order Trade-off Pecking-order

(Huang & Song,

2006) Pecking-order Trade-off Trade-off Pecking-order (Zou & Xiao,

2006) Pecking-order Trade-off Trade-off Trade-off

(Bhabra et al.,

2008) Pecking-order Trade-off Trade-off Trade-off

(Qian et al.,

2009) Pecking-order Trade-off Trade-off (Li et al., 2009) Pecking-order Pecking

Order Trade-off (Chang et al.,

2014) Pecking-order Trade-off Trade-off Pecking-order Table 2 Previous researches and the capital structure theories.

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Table 2 summarizes which theory supports results of the previous researches in China. However, as can be seen, none of the researches is fully supported by any of the theories. The trade-off theory is often criticized for its prediction of negative relationship between profitability and the leverage, which is the main reason it is often

rejected(Strebulaev, 2007). Perhaps one of the updated dynamic trade-off theory models, which says companies with higher profitability face less financial distress and can borrow more money would be a better suit for the Chinese market and make it appear dominant over the pecking-order theory. However, even then only two of the researches would find consensus regarding the theory that Chinese companies follow when choosing financial leverage levels, which shows that Chinese market is indeed quite unique and what works in other countries, does not necessarily apply to China.

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3. Data sample and model