What factors might explain the capital structure of listed real estate firms in China?

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1 Department of Real Estate and Construction Management Thesis no. 26 Real Estate Development and Financial Services Real Estate Management Master of Science, 30 credits What factors might explain the capital structure of listed real estate firms in China? Author: Liufang Li Supervisor: Han-Suck Song Stockholm 2010

2 Master of Science thesis Title: What factors might explain the capital structure of listed real estate firms in China? Authors Liufang Li Department Department of Real Estate and Construction Management Master Thesis number No. 26 Supervisor Han-Suck Song Keywords Capital structure, Trade-off, Pecking order, Chinese listed real estate firms, State-controlled enterprises, Static panel data model, Dynamic panel data model Abstract This paper is an empirical study investigating the determinants of capital structure of listed real estate firms in China in the period of Using a panel data set, both static and dynamic panel data models are estimated. The significant and positive determinants are estimated to be the total asset, the state owned share percentage and tangible asset ratio. While the significant and negative determinants are estimated to be the growth rate of the income and return on assets. The lagged effects of explanatory variables are found to explain the current debt ratio significantly according to the estimated dynamic model. The estimation results are compared with the literature study of capital structure theories including Miler and Modigliani Theory, trade-off theory and pecking order theory. An attempt has been made to study market-timing theory and institutional factors influencing on capital structure decision. Most of the estimation from the models is consistent with the trade-off theory and pecking-order theory. However, these two theories cannot fully provide convincing explanations for the capital choices of the Chinese real estate listed firms. Instead, some of the results are explained by the practical situation gained from series of interviews with Chinese developers, which suggesting that the institutional differences and financial constraints in the capital markets especially for real estate firms in China are also the factors influencing firms capital structure decisions. I

3 Acknowledgement There are a lot of people who gave me support during my thesis writing. First of all I own my gratitude to my supervisor Han-Suck Song who guided me and gave me valuable advice in the whole process. My gratitude also gives to Jiang Liang who assisted me with the section of empirical study in this thesis. In addition, I am thankful to ShuoWang and Yue Xiao who helped me to get substantial accounting and market data of Chinese listed real estate firms from China Stock Market and Accounting Research Database (CSMAR). Also, I would like to thank Zehao Xie, Miaorong He, Zhanhong Lu etc. from Chinese listed real estate firms providing me with their experiences and information about the topic of capital structure. I am very grateful to all the lecturers in the master programme of Real Estate Management at KTH who imparted me knowledge that is useful for this thesis as well as my future career. Last but not least, my appreciation goes to my family and friends for their constant love and support. Stockholm, 18 th May 2010 Liufang Li II

4 Table of Content Master of Science thesis... I Abstract... I Acknowledgement... II Table of Content... III Chapter One - Introduction Background Problem statement Aims and research questions Methodology Limitation Disposition... 3 Chapter Two - Theoretical Framework on Capital Structure Theory of capital structure The Miller and Modigliani theory The trade-off theory The pecking order theory The market timing theory Literature review on capital structure determinants Empirical findings from Chinese perspective Real estate related empirical findings Determinants of capital structure Chapter Three - Descriptive Statistics Sample set Development of listed real estate firms Chinese listed real estate firms have quite low leverage level High short-term vs. low long-term debt ratios Most of the listed real estate firms are state-controlled Chapter Four - Empirical Analysis on Determinants of Capital Structure Variables Static panel data models Dynamic panel data model Regression results and interpretation Static panel model Dynamic panel model Summary of findings Chapter Five Conclusion Conclusion Reference III

5 Chapter One - Introduction 1.1 Background Since the late 1970s, China has experienced a transitional process from a planned to a market economic system. At the beginning of formation of capital market, only state-controlled enterprises were listed in the exchanges, which refer to the enterprise that used to be a state-owned business but later became a listed company, in which the state still keeps controlling shares. They were usually granted generous loans from state-owned banks to improve their financial condition. Furthermore, imperfect legal system and underdeveloped financial system hampered the growth of the Chinese capital market. In order to rectify and standardize the order of the market economy, a series of economic reforms has been launched. The economy has been gradually transferred from dominating state owned enterprises to a mixed economy, while the state still plays a significant dual role as a regulatory agency and owner of firms. Over the years, Chinese firms have achieved remarkable success in expanding growth. This biggest developing country grabs attention from all over the world. Due to the distinct features in China s financial markets, it is worthy to examine whether the debt financing behavior in Chinese public listed firms can be explained by the theories derived from the western settings. Schwartz & Aronson (1967) find that the capital structure choices differ among industries. A majority of the empirical studies has proved the strong industry effect. Focusing on a specific type of industry can yield this effect. In particular, real estate has unique characteristics, which is famous as a source of collateral for mast amounts of debt. Also, they are comparatively safe or defensive stocks, and equity performance is likely to be closely tied to the underlying assets which are frequently valued and held at market value on the Balance Sheet (Bond & Scott, 2006). Owusu-Ansah (2009) provides evidence from Sweden that real estate firms borrow more than those in the IT and the health care industries. Morri & Cristanziani (2009) analyze the determinants of 1

6 capital structure of real estate companies in European countries, showing the result is consistent with pecking order theory and trade off model. Singh (2002) review the evolution of innovative debt and equity structures in U.S. real estate finance, such as securitization, Commercial Mortgage Backed Securities (CMBS), Collateralized Mortgage Obligations (CMO) and Real Estate Investment Trusts (REITs), which provide a lot of options except for traditional debt and equity capital sources. Compared with developed countries, China's real estate finance is less developed and immature due to a short history of real estate market started from Although in recent years, the real estate finance has been diversified; problems of undeveloped corporate markets, imperfect legal system for REITs and strong policy control on this sector still exist. Thus, it is necessary to analyze the determinants of capital structure in Chinese real estate industry in the condition of the unique features, combined with institutional factor and real estate industry. 1.2 Problem statement Although a lot of theoretical and empirical studies have been done in the area of capital structure, most of them focus on the firms in developed countries. Few studies have been undertaken in the developing counties, where the capital markets are in a nascent phase. Further, the real estate has unique features that made them interesting to study. Wang (2003) and Lin (2006) in our school made attempts to study the Chinese real estate financing behavior in the way of descriptive statistic analysis, questionnaire and interview investigation, which provides deep insights. As discussed above, the unique features of institutional factor and real estate industry brings necessity to further analysis the capital structure determinants in China. 1.3 Aims and research questions The central purpose of this research is to find out the main determinants of capital structure in Chinese real estate listed companies, and analyze whether the trade off theory and pecking order theory can be applied to them. Besides, this study makes an 2

7 attempt to find out whether state-owned shares have impact on the capital structure for real estate listed firms. 1.4 Methodology The study is mainly based on quantitative methods, and series of interviews are conducted to explain the quantitative results. Descriptive statistic analysis is undertaken to fully understand the feature of capital structure for Chinese listed real estate firms in the period of An empirical analysis is made to test the capital structure determinants for Chinese real estate listed companies. This empirical study uses a data set of both market and accounting data in time period of for real estate companies listed in Shanghai and Shenzhen stock exchanges. The source of this data set is China Stock Market and Accounting Research Database (CSMAR) developed and maintained by Shenzhen GTA Information Technology Co. in China. 1.5 Limitation Only listed companies are researched in this study due to the availability of data, although the unlisted real estate makes up the large proportion of China s real estate industry. This limitation, to some extent, also renders the problem of biased result since most of listed real estate firms are large. Besides, because of the different accounting system, this study only examines the real estate companies listed in the exchanges of mainland with exception of the Hong Kong exchange where a lot of mainland s private-owned real estate companies are prone to go public due to less regulation and better transparency. Again, due to the data limitation of the share ownership and fixed assets, a panel data regression is conducted in the period of to examine determinant of capital structure. 1.6 Disposition This study is divided into four chapters. Chapter one is an introduction of country 3

8 factors and industry factors for capital structure, and to describe purpose, method and limitation of this study. Chapter two generates a framework of main capital structure theories, identifies the potential determinants of capital structure, and made hypothesizes for empirical study. Chapter three is descriptive statistic analysis in terms of leverage ratios, short-term debt ratios, long term debt ratios and state ownership. Chapter four is an empirical study by making panel data regressions to find out the main determinants of capital structure. Chapter five presents the results of the quantitative study and analyzes the findings. 4

9 Chapter Two - Theoretical Framework on Capital Structure 2.1 Theory of capital structure A firm s basic capital resource comes from the stream of cash flow produced by its assets. Once there is a gap between internal equity and the cash that the firm need, the firm must finance this gap by issuing equity, debt or hybrid securities. The term capital structure refers to the mix of different types of securities (long-term debt, common stock, preferred stock, convertible debt, etc) issued by a company to finance its assets (see e.g. Song, 2005). There is always a question: How do firms choose their capital structure? A lot of theories have been developed to answer this puzzling question. This chapter reviews the primary theories of capital structure choices containing the Modigliani and Miller theory, trade off theory, pecking order theory and market timing theory in order to establish a theoretical framework for the consequent empirical study The Miller and Modigliani theory Modigliani and Miller (1958) made a breakthrough development on establishing the first important theory of the capital structure. When financial managers are trying to find the particular combination that maximizes the market value of the firm, Modigliani and Miller s (MM s) famous proposition 1 states that no combination is better than any other in a perfect market. The firm s value is determined by its real assets, not by the securities it issues. It implies the financing choices do not affect the firm s investment, borrowing, and operating policies. It also implies the choices of long-term versus short-term debt should have no effect on the overall value of the firm (Brealey, Myers, & Allen, 2008). Furthermore, the MM s proposition 2 states that the capital structure does affect the expected rate of return on the common stock. According to the weighted-average 5

10 cost of capital (WACC) developed by MM, return on equity increases in proportion to the debt-equity ratio, but any increase in expected return is exactly offset by an increase in risk and therefore leaving stockholders no better or worse off. MM s two propositions are all based on the assumption of a perfect capital market where there is no transaction cost related with capital raising or going into bankruptcy, where there is no taxes and where there is disclosure of all available information (Huang & Song, 2006). Although debt policy rarely matters in perfect markets, it is not a practical guideline to employ in a real capital market with frictions and imperfection. MM s theory cannot explain the fact that debt ratios vary regularly from industry to industry. For instance, almost all real estate development companies rely heavily on debt while high-tech growth companies rarely use much debt. No matter what, MM theory is considered as a starting point of capital structure theory The trade-off theory Evolved from MM theory, Miller (1977) finds it does exists an optimal capital structure when taking consideration of corporate and personal taxes, bankruptcy costs and agency costs. The trade-off theory successfully explains industry differences in capital structure. Firm s debt-equity decision is a trade-off between interest tax shields and the costs of financial distress. The trade-off theory of capital structure recognizes that target debt ratios may vary from firm to firm. Companies with safe, tangible assets and plenty of taxable income to shield ought to have high target ratios, while companies with risky, intangible assets ought to rely primarily on equity financing. The theoretical optimum is reached when the present value of tax savings due to further borrowing is just offset by increase in the present value of costs of distress. (Brealey, Myers, & Allen, 2008) According to the trade-off theory, different firms should set their own target ratios that maximize firms value. This is so called static trade-off theory. 6

11 Figure The Static Trade-off Theory of Capital Structure Source: (Miller, 1977) Furthermore, the costs of adjusting capital structure constrain the adjustment speed toward the companies target debt ratio. Thus the differences of actual debt ratios are observable although their target debt ratios are the same. This is labeled as the dynamic trade-off theory. Although trade off theory can explain many industry differences in capital structure, it cannot explain the fact that some of the most profitable companies borrow the least. Under the trade-off theory, high profits imply higher market value and more taxable income to shield thus should have strong incentives to borrow. It predicts the reverse of how companies actually behave. Now the pecking order theory is presented below in light of this problem The pecking order theory Pecking order theory is a completely different theory of financing. First suggested by Myers and Majluf (1984), it starts with the assumption of asymmetric information, indicating that managers know more about their companies prospects, risks, and values than do outside investors. Companies try to time issues when shares are fairly priced or overpriced. Investors understand it and the stock price usually falls when a stock issue 7

12 is announced. Thus when companies need external financing they prefer debt to underpriced external equity. This leads to a pecking order, in which investment is financed first with internal funds, reinvested earnings primarily; then by new issues of debt; and finally with new issues of equity. (Brealey, Myers, & Allen, 2008, p.517) This theory has no well-defined optimal target debt ratio because the current leverage of a firm reflects its cumulative requirements of external financing (Morri & Cristanziani, 2009). Pecking order theory assumes the attraction of interest tax shields is the second order. Debt is better than equity when the problem of asymmetric information is considered as the most important issue The market timing theory Market timing theory is developed from behavioral corporate finance. In the inefficient or segmented capital markets, the investors are sometimes not as rational and stable as the financial managers. Then the managers can take advantage by issuing shares when the stock price is high and switch to debt when the price is low. In other words, equity market timing refers to the practice of issuing shares at high prices and repurchasing at low prices (Baker & Wurgler, 2002). Market timing can explain why companies tend to issue shares after run-ups in stock prices and also why aggregate stock issues are concentrated in bull markets and fall sharply in bear markets. (Brealey, Myers, & Allen, 2008) Market timing theory has been examined recently. Baker and Wurgler (2002) find that market timing has large, persistent effects on capital structure. They documents the leverage of firms is negatively associated with their historical market valuation, as measured by the market-to-book ratio. It implies the temporary fluctuation in market valuation have long run impact on capital structure. Huang and Ritter (2004) study the external financing decisions of publicly traded U.S. firms, identifying that a large proportion of their financing deficit is financed by the external equity when the expected equity risk premium is low. The empirical studies of market timing theory in China are not consistent. Liu et 8

13 al. (2006) find that the market timing has a long run effect on capital structure and the time length is five years. Li (2006) find that the market timing does have impact on the capital structure but it is not persistent. Hu et al. (2008) suggest that market timing has little influence on the capital structure. In this thesis, due to the limitation of data the effect of market timing cannot be tested in quantitative study. 2.2 Literature review on capital structure determinants This section develops a framework to justify which factors affect the capital structure of listed firms by reviewing the empirical studies internationally, in China and in the area of real estate respectively, then discusses the determinants that will be measured in the coming study. The theoretical and empirical studies in this field are extensive. Harris & Raviv (1991) summarizes a number of empirical studies from US firms, suggesting that leverage increases with fixed assets, non-debt tax shields, investment opportunities and firm size, and decreases with volatility, advertising expenditure, and the probability of bankruptcy, profitability and uniqueness of the product. (p. 334) Recently, academics have started to concern about the situation of capital structure in developing countries. They generally show the factors that traditionally explain the cross-section of leverage in the US are similarly correlated in other countries, but also identify the consistent difference across countries, which indicate the impact of different institutional features. Rajan and Zingales (1995) looked at the difference in leverage and its determinants in the G7 countries: US, Japan, Germany, France, Italy, UK and Canada. They find that aggregate leverage and determinants are both roughly identical across these countries. Booth et al. (2001) focused on 10 developing countries, showing that capital structure is affected by the same variables as in developed countries. However, a persistent impact of institutional features on capital structure is prominent, which is still not fully understood. Furthermore, Fan, Titman, and Twite (2008) examines the influence of institutions on the capital structure in cross-section of firms in 39 developed and developing countries. They find different 9

14 legal system; taxes and the characteristics of the financial institutions explain the cross-country variation in leverage. Although a lot of empirical studies have been done to test the determinants of capital structure, it is found that other determinants are used based on different understanding. It implies that arguments still exists on this issue Empirical findings from Chinese perspective China, the biggest developing country in the world, with the significant institutional differences and financial constraints in the banking sector (Chen, 2004), arouses researchers interest to study its determinants of capital structure. Chen (2004) develops a preliminary study to explore the determinants of capital structure in China using firm-level panel data of 77 Chinese public-listed companies over the period , identifying special features of the China s corporatization and its institutional environment which influence the firms leverage decision. He found that neither the trade-off model nor the Pecking order hypothesis derived from the developing countries provides convincing explanations for the capital choices of the Chinese firms. The capital choice decision of Chinese firms seems to follow a new Pecking order retained profit, equity, and long-term debt. And it was pointed out that further work is required to develop new hypotheses for the capital choice decisions of Chinese firms and to design new variables to reflect the institutional influence. Huang and Song (2006) use a database containing the market and accounting data in period of from more than 1200 Chinese-listed companies to document their capital structure characteristics. While they report state ownership or institutional environment has no significant impact on capital structure. The reason is stated that state ownership enterprises (SOEs) follow the basic rules of market economy, even if the state does not give up its controlling right. And it implies competition helps in the reform of SOEs. The empirical study of this article indicates that as in the developed countries, leverage in Chinese firms increases with firm size and fixed assets, and decreases with profitability, non-debt tax shields, growth opportunity, managerial 10

15 shareholdings and correlates with industries. However, Chen (2004) and Huang & Song (2006) both agree on Chinese firms prefer short-term finance and tend to have much lower long-term debt, which is different from western setting. In recent years, Qian, Tian, & Wirjanto develope a series of study on capital structure and corporate governance in China. They (Qian, Tian, & Wirjanto, 2007) attempt to validate the work Chen (2004) and Huang & Song (2006) have done by applying a larger panel-data set in over a more recent time period ( ). And unobserved cross-sectional and time effects as well as industry effects are taken into consideration. Their empirical results show that firm size, tangibility and ownership structure are positively associated with firm s leverage ratio, while profitability, non-debt tax shields, growth and volatility are negatively related to firm s leverage ratio. Furthermore, Qian, Tian, & Wirjanto (2009) study the dynamic capital structure model for 650 Chinese publicly listed companies in the period of They formulate a dynamic panel-data model to test whether and to what extent the reforms have succeeded in providing incentives for Chinese PLCs to achieve the target levels of their capital structures. One of their main findings is that Chinese firms adjust toward an equilibrium level of debt ratio in a given year at a very slow rate, indicating the existence of financial costs prevent companies constantly rebalance leverage ratio. Bharbra, Liu, & Tirtiroglu (2008) examine the capital structure decisions of listed firms in China between 1992 and They emphasize the unique features in China with high information asymmetry, phenomenal growth, highly concentrated ownership, and a lack of external market for corporate control. Their empirical study shows the leverage is positively related to firm size and tangibility, and negatively related to profitability and growth options. Li, Yue & Zhao (2009) highlight the important role of ownership structure and institutional development when studying capital structure in emerging market like China. They employ a data set in debt financing of Chinese non-public manufacturing firms derived from National Bureau of Statistics (NBS) in the period of The empirical study shows that the expansionary power of ownership structure and 11

16 institution (6%) in leverage decisions is closed to the power of firm characteristics (8%) Real estate related empirical findings Real estate is a capital-intensive sector. The capital demand of real estate industry is very high. It requires real estate firms resort to external fund to finance tremendous cost in the process of purchasing land and construction. Also, real estate firms have a great deal of collateral to support high levels of debt. According to the trade-off theory, this means the costs of financial distress are likely to be lower than average, indicating real estate s optimal capital structure tends to be higher than other industries. Owusu-Ansah (2009) provides evidence from Sweden, identifying real estate firms borrow more than those in the IT and the health care industries. From the existing literature, debt financing behavior in real estate sectors varies from different countries because of different institution environment and development phase. Morri & Cristanziani (2009) analyze the determinants of capital structure of real estate companies in European countries, showing the result is consistent with pecking order theory and trade off model. Singh (2002) review the evolution of innovative debt and equity structures in U.S, such as securitization, Commercial Mortgage Backed Securities (CMBS), Collateralized Mortgage Obligations (CMO) and Real Estate Investment Trusts (REITs), developed in the period of national recession combined to shut off funding for hotel projects in the early 1990s. Ooi (2000) examines the ownership structure of 83 property listed companies in UK and document nearly one fourth of the common shares issued by the companies are held by the managers. He highlights the problem of managerial opportunism in the corporate governance because of separating ownership from management. Bond & Scott (2006) examines the pecking order theory and trade-off theory by testing on a sample of 18 UK listed real estate, showing that real estate financing can be explained by broader capital structure framework in which information asymmetries drive firm financing behavior. 12

17 Current studies more focus on examining the capital structure decision for Real Estate Investment (REITs). Feng, Ghosh and Sirmans (2007) find that the pecking order is mostly relevant in explaining the capital structure U.S. REITs where the costs of asymmetric information exceed the costs of financial distress. Morri & Cristanziani (2009) examines both REITs and non-reits companies in European countries. Because REITs are exempted from the payment of taxes if most of the taxable income is paid out to shareholders as dividend, this finding confirms the importance of the tax-exempt status in affecting capital structure choices. They also find that non-reit companies are significantly more leveraged than REITs. However, in China REITs are still in the early phase of real estate finance facing regulatory constraints. Few literatures can be found in empirical study of capital structure choice in Chinese real estate listed firms. Dai (2004) tests 35 real estate listed companies in China in the period of 2000 to 2002, showing that variables of firm characteristics are almost not related to capital structure with the exception of the corporate velocity which has significant negative relation to short-term debt ratio. Also, tax shield effect is positively related to the capital structure to some extent, while the samples are not extensive enough to explain capital structure decision. Li, Luo, & Ao (2005) examine 46 real estate listed companies in 2003 and find most of the real estate companies in China have state-owned stock with high liability. Their empirical study suggests that the profitability, size and the property guarantee value are negatively related to the total leverage. Growth and shareholders equity are positively related to the total leverage of the real estate listed companies.however, the choices of determinants did not be fully explained in their study Determinants of capital structure Based on the literature review, the following variables are selected and will be measured in the consequent empirical study. Size Theoretically, the relationship between size and leverage is unclear. The Trade-off 13

18 theory states that large firms tend to be more diversified and less prone to bankruptcy. They usually have lower transaction costs associated with long-term debt issuance, and are able to issue debt at a cheaper rate than small firms. (Titman & Wessels, 1988) On the other hand, pecking order theory suggests the negative relationship between size and leverage. Informational asymmetries problem is expected to be lower for large firms, thus large firms should be more capable of issuing informational sensitive securities such as equity (Kester, 1986). Empirical study such as Booth et al. (2001), Marsh (1982), Rajan and Zingales (1995), and Wald (1999), find that leverage is positively correlated with firm size. Marsh s (1982) survey of literature concluded that large firms more often choose long-term debt while small firms choose short-term debt. Furthermore firm size has different measures. Since most existing literatures show the size effect on leverage is nonlinear, natural logarithm of assets or sales are used to measure this variable. In this study, it is defined as the logarithm of assets. Profitability Pecking order theory indicates a negative relationship between profitability and debt. Profitable firms prefer internal funds rather than external due to asymmetric information or transaction costs. Furthermore, Jensen (1986) predicts a negative relationship if the market for corporate control is ineffective. In addition, Fan, Titman, and Twite (2008) identify that the relationship between profitability and leverage tends to be stronger in countries with weaker shareholder protection. In this study it is hypothesized that profitability is negatively related to the leverage. The year return of asset (ROA) is used as measure profitability. Growth opportunities Theoretical studies generally suggest an ambiguous relationship between growth opportunities and leverage. The trade-off theory predicts that firms with more investment opportunities will be characterized by a lower amount of debt. Although the empirical result in China confirms the same relationship, Chen (2004) identifies the trade-off model does not apply to the Chinese firms due to low technology level of Chinese firms. According to the pecking order theory, higher growth opportunities 14

19 imply higher capital demand and a greater preference for external financing through preferred source of debt. This suggests a positive relationship between growth and leverage. However, due to agency costs, firms investing in assets that may generate higher growth opportunities in the future face difficulties in borrowing against such assets (Myer, 1977). This suggests a negative relationship. Myers (1977) also pointed out that this agency problem is relieved if the firms issues short-term rather than long-term debt. Therefore, we may expect that short-term debt is positively related to growth. There are different proxies for growth opportunities. Rajan and Zingales (1995) use Tobin Q defined as market-to-book ratio of total asset. Tobin Q is a measure for future growth opportunities. Due to the availability of the data, sales growth rate is used to examine the relationship with growth and leverage. Tangibility A positive relationship exists because tangible assets are easy to collateralize for debt, especially for long-term loans. According to trade-off theory, tangible assets serve as good collateral to support debt. Also, cost of financial distress is lower with high tangibility. Thus firm with significant tangible assets such as real estate would be expected to employ more debt than average. Chen (2004) confirms a positive relationship between tangibility and leverage in China. It shows that asset tangibility is an important criterion in banks credit policy, and this is particularly true for long-term loans. So it is assumed that the long-term loans of real estate companies are higher than average level. This study follows Rajan and Zingales (1995) by defining tangibility as the ratio of fixed assets over total assets. In this study, net value of fixed assets and construction-in-progress are added up as value of fixed assets. Liquidity According to the trade-off theory, firms decision of debt-equity ratio is a trade-off between interest tax shields and the costs of financial distress. The financial distress of the firm is measured as liquidity ratio. It expresses a company s ability to repay short-term credits from banks. In Chinese listed real estate firms, short-term debt dominants the majority of the total debt. Higher liquidity ratio indicates the lower 15

20 probability of financial distress. Here the liquidity ratio is predicted to be positive related with the debt ratio. Tax shield According to MM theory, interest tax shield generate incentives for firms to raise leverage. Interest on debt is a tax-deductible expense which creates a tax shield. A positive relationship between tax shield effects and leverage is expected in this study. Ownership structure Agency theory suggests two types of conflicts in ownership structure: conflict between share holders and managers, and conflicts between shareholders and debt holders. It is expected to have a correlation between ownership structure and leverage. However, there are some distinct features of ownership structure in China s stock market. Shares are categorized as A shares, which are specified for domestic investors, and B shares, which are specified for foreign investors. Further, A-shares are classified as tradable shares held mainly by public investors, and non-tradable shares consisting of legal-person shares and state shares owned by either the central government or the local government. Since the formation of stock markets aimed to contribute to the growth of state-owned enterprises, the non-tradable shares issue was designed as a way to manage state assets through capital markets. According to statistics of CSRC, as of the end of 2004, 64% of the total billion shares issued by Chinese listed companies were non-tradable in nature, of which state-owned shares accounted for 74%. The existence of non-tradable shares has seriously constrained the internationalization and further development of China s capital markets, such as problem of dual-pricing of shares of the same listed companies. Thus the non-tradable share reform was initiated in April 2005, aiming to eliminate the difference between tradable and non-tradable shares. By the end of 2007, 98% of total listed companies had either started or finished the process of the reform. However, the amount of floating shares is still very low, accounting for less than 30% of the entire share outstanding. It indicates that after 20 years of economic reforms, state in capital market still plays a dual role as a majority shareholder as well as the owner of major banks. 16

21 Trade-off theory indicates that ownership structure affects companies capital structure. The literatures on state ownership shows that state-owned shares strengthen the firm s access to debt, and lending decisions of state-owned banks are politically motivated. (Khwaja & Milan, 2005; Dinç, 2005) Empirically, Gordon & Li (2003), and Allen et al. (2005) indicates that Chinese SOEs receive a large share of credit issued by state-owned banks. Thus in this study share-owned share is hypothesized to be positively related to leverage ratio. Table Summary of the implications of capital structure theories and hypothesis as well as measurement in this study Determinants Expected sign by Hypothesis of theories this study Measurement profitability + (trade off) - return on asset - (pecking order) size + (trade off) + logarithm of total assets - (pecking order) growth opportunities - (trade off) + sales growth rate + (pecking order) tangibility + (trade off) + fixed asset/total assets liquidity +(trade off) + currency ratio Tax-shield +(trade off) + logarithm of year debt interest state-owned share ambiguous + state-owned shares/total shares 17

22 Chapter Three - Descriptive Statistics 3.1 Sample set This quantitative study uses an unbalanced panel data set of both market and accounting data in time period of for real estate companies listed in Shanghai and Shenzhen stock markets. The source of this data set is China Stock Market and Accounting Research Database (CSMAR) developed and maintained by Shenzhen GTA Information Technology Co. in China. Among the sample set, those firms with missing observations, abnormal leverages (more than 100%) are excluded from the sample. Table Mean and Median Leverage ratios, short-term debt ratios and long term debt ratios for sample listed firms during Year N Total liability/total assets Short-term debt/capital Long-term debt/capital Mean Median Mean Median Mean Median % 66.5% 65.9% 65.9% 0.6% 0.6% % 59.4% 55.8% 58.4% 7.4% 0.0% % 46.6% 39.6% 36.6% 5.2% 1.8% % 48.4% 43.4% 45.2% 4.4% 2.1% % 53.1% 46.9% 45.9% 5.8% 3.5% % 46.9% 41.0% 43.4% 5.2% 1.8% % 47.4% 40.2% 40.8% 5.2% 1.2% % 47.9% 43.7% 44.7% 4.3% 2.4% % 48.8% 46.1% 45.9% 3.3% 1.8% % 47.8% 44.2% 42.2% 4.6% 2.2% % 47.6% 45.2% 42.4% 5.1% 2.3% % 51.2% 43.8% 1.9% 12.5% 4.3% % 54.9% 47.0% 47.4% 7.8% 4.7% % 59.4% 48.9% 48.8% 8.4% 5.2% % 58.5% 50.3% 48.3% 8.5% 7.9% % 61.6% 46.3% 46.7% 12.9% 10.3% % 59.4% 42.5% 43.4% 13.7% 13.9% Average % 53.3% 46.5% 44.0% 6.8% 3.9% Note: Capital = total debt + book value of equity 18

23 Figure Average leverage ratios, short-term ratios and long term ratios 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% Leverage (Mean) Short-term debt ratio Long-term debt ratio 10.0% 0.0% Development of listed real estate firms China reopened its stock markets in 1991, nearly 40 years after they were closed in The two stock exchanges are located in Shanghai and Shenzhen. In 1993, intuitional framework and supervisory framework were established with the formation of the China Securities Regulatory Commission (CSRC) which supervises and consolidate the capital market nationwide. According to the Industry Classification Standard of Chinese Listed Companies issued by CSRC, real estate sector includes Real Estate Development and Operation, Real Estate Management, and Real Estate Intermediate Service. In the sample set, there was only one real estate firms listed in Shenzhen stock market in 1991, and till the end of 2007, 70 real estate firms were listed in Shanghai and Shenzhen exchanges by IPO and back-door listing. At the early phase of the Shenzhen and Shanghai exchanges established, a lot of real estate firms were listed in the stock markets with encouragement policies. Till the end of 1993, the number of real estate listed firms accounted for 10% of the total number of listed firms. Since the latter half of 1994, state had launched a series of measures in order to restrain the overheating of real estate. In 1995, CSRC refused all the rationed shares application raising funds for the luxurious apartments, villas, resorts, offices and the hotels of four-star standard and above. In terms of IPO, CSRC 19

24 did not accept and heard any case of financial and real estate enterprises until During this period, some real estate firms resorted to back-door listing due to a strong capital demand. Even after 2001, only a few real estate companies could be listed which were mostly state-controlled enterprises, and many real estate firms had to choose overseas listing or back-door listing. 3.3 Chinese listed real estate firms have quite low leverage level. In this study the leverage is measured as total liabilities over total assets, which is the broadest definition of leverage. The yearly mean leverage accounts for 51.7% and the corresponding median amounts to 53.3%. Both figures are lower than the leverage level of total listed firms (56%) over this period, while they are much lower than the mean leverage of total real estate developers in China (80%). 1 It indicates that listed real estate firms have a strong desire of equity finance. The reasons for this equity finance preference are investigated by interviews. Most of listed real estate firms resort to external finance especially equity finance rather than accumulation of internal funds. First, equity finance is less costly than debt finance due to a relatively high PE (price/earnings) ratio with an average level above 20. High PE ratio leads to high share issue price thus the listed firms have substantial gains from stock markets. Also, the low rates of dividend distribution of listed real estate firms further reduce the cost of equity finance. Second, according to the statistics from People s Bank of China, retail investors occupied more than half proportion of the total market capitalization in 2007, while the institutional investors only accounted for 30%. This unbalance contributes a high volatility in the stock market. It is because institutional investors are able to lower the risks due to diversification and long-term investment horizon, while retail investors tend to act as herd behavior or more sentiment-driven. Third, agency problem exists in state-controlled enterprises where managers and shareholders are detached, and 1 Data arranged from China Statistical Bureau

25 managers tend to issue more equity for financing. Besides, as Chen (2004) states due to series of corporate governance problems and the lack of enforcement of company laws, individual shareholders do not have adequate investment protection. Share capital has become somewhat a free source of finance. 3.4 High short-term vs. low long-term debt ratios The unbalanced between the short-term and long-term debt ratio shows that real estate listed firms prefer to use short-term loans rather than long-term debt, which is consistent with the empirical study of capital structure for overall China s listed firms. As the figure 3.1 shows, long-term debt ratio has an upward trend during , although it is still much lower than short-term debt ratio. The main reason is that bond markets are growing rapidly in China, but it is still very difficult for real estate companies to get long-term financing from relatively undeveloped corporate bond markets. As an alternative way to raise capital other than by issuing equities or directly borrow money from banks, corporate bonds can provide long-term capital without diluting shareholder interest, and there is no strict limitation imposed on the usage of the funds compared to bank loans. However, China s bond market is still very small compared to mature economies. In the early 1990s when China just opened the market, the overheating of the economy and excessive corporate bond issuance resulted in a high default rate and even disturbed the issuance of government bonds. Thus the government strengthened the regulation of bond markets by limited quota and strict administrative controls. The bond markets have developed very slowly until recent years, when The Pilot Rules on the Issuance of Corporate Bonds was promulgated in May Currently in China, there are four types of corporate bonds: enterprise bonds, convertible bonds, short-term corporate financing bills, and listed company bonds. Enterprise bonds are the earliest type of corporate bonds in China and they are usually allowed to be issued by the large-scale state-owned enterprises while listed company 21

26 bonds were just introduced to the exchanges in 2007, issued by listed companies and traded in the exchanges. Thus most Chinese real estate listed firms tend to have short-term debt financing. 3.5 Most of the listed real estate firms are state-controlled Due to the availability of data, the type of listed real estate firms is analyzed in the period of The firms with state-owned shares dominate the majority of total listed real estate firms. The statistics are consistent with the empirical study by Li, Luo, & Ao (2005) that the state-controlled listed real estate firms lead the whole industry and use the main part of available loans in banks thus the development of real estate to some extent depend on the state-controlled companies success. Table3.1.4 Type of firms Type of firms Firms with state-owned shares Firms with private owned Total number In addition, during the number of private owned firms was increasing and the number of state-controlled firms was decreasing due to the non-tradable share reform. This reform is called forth by a distinct feature of Chinese stock markets. In China, equity structure of most listed companies has been segmented. A-shares are classified as tradable shares held mainly by public investors, and non-tradable shares largely owned by central or local governments. Since the formation of stock markets aimed to contribute to the growth of state-owned enterprises, the non-tradable shares issue was designed as a way to manage state assets through capital markets. According to statistics of CSRC, as of the end of 2004, 64% of the total billion shares issued by Chinese listed companies were non-tradable in nature, among which state-owned shares accounted for 74%. However, the existence of non-tradable shares has seriously constrained the internationalization and further development of China s capital markets, such as problem of dual-pricing of shares of the same listed companies. Thus the non-tradable share reform was initiated in April 2005, aiming to 22

27 eliminate the difference between tradable and non-tradable shares. However, the amount of tradable shares is still low; the state shares remain a significant role of the listed real estate firms. 23

28 Chapter Four - Empirical Analysis on Determinants of Capital Structure This study relies on quantitative methods as the main methodology. An empirical analysis is made to test the capital structure determinants for Chinese real estate listed companies. Due to the data limitation of state-owned share percentage and fixed assets ratio, the analysis is conducted by using a panel data linear regression model where the dependent variable is leverage ratio during the time period of In this chapter, static and dynamic panel data models are introduced, and the results from these two models are tested and interpreted respectively. 4.1 Variables According to the research objectives and the literature research this study has made in the previous chapters, the measurements of variables are chosen and presented in the following table. Table Measurement of variables Variables Dependent variables Leverage Independent variables Firm size Profitability Growth opportunities Tangibility Liquidity Debt interest State-owned shares Measurement total liabilities/total assets The regression model is constructed as follow expression: logarithm of total assets return on asset gross income growth rate fixed asset/total assets currency ratio logarithm of year debt interest state-owned shares/total shares LEV = f(size, FtT, ROA, GrowthR, CR, TaxS, Ownership) (3.1) The dependent variable LEV means the debt ratio, the size is the total assets, the FtT is the ratio of the fixed assets and total assets, the GrowthR is the growth of gross income and total assets, the variable CR is the liquidity ratio and the TaxS is tax shield. The 24

29 percentage of the government share in the total equity share is used to indicate the ownership of the real estate company. Table Summary of the variables Variable Mean Std. Dev. Min Max Observations year overall N 299 between n 63 within T-bar leverage overall N 299 between n 63 within T-bar growth overall N 299 between n 63 within T-bar tangibility overall N 299 between n 63 within T-bar state-owned shares overall N 299 between n 63 within T-bar currency ratio overall N 298 between n 63 within T-bar 4.73 ROA overall N 299 between n 63 within T-bar size overall 4.16E E E E+11 N 299 between 6.34E E E+10 n 63 within 4.88E E E+10 T-bar lndebt interest overall N 293 between n 63 within T-bar As the table above shows, there are 63 real estate companies are being researched in our models. The time panel for the research is from 2003 to 2007.All the variables vary both within and between individual companies. 4.2 Static panel data models Panel data models are classified according to their assumptions regarding the source of 25

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