Academic journal article Quarterly Journal of Finance and Accounting

Cost of Capital Techniques Used by Chinese Firms: A Survey of Practice

Academic journal article Quarterly Journal of Finance and Accounting

Cost of Capital Techniques Used by Chinese Firms: A Survey of Practice

Article excerpt

Introduction

This paper presents the results of a survey of how Chinese firms compute the cost of capital and how they utilize it in their decision making. The cost of capital is commonly defined in finance textbooks as the weighted average of the costs of each capital claim in a firm's capital structure. Alternatively, it is defined as the return a firm must earn to cover the returns required by the firm's capital suppliers. The cost of capital is a key input in valuing companies; in designing capital structure to maximize the value of the firm; in assessing the value added by long-term investments; and in the effective acquisition, maintenance and divestment of real assets.

The cost of capital has also been proposed as an explanation for the dwindling of U.S. dominance in the world market. For example, Hatsopoulous (1983) argued that the low cost of capital in Japan allowed Japanese managers to undertake long-term projects that their U.S. counterparts would not accept. Consequently, a number of studies have tried to compare the cost of capital facing U.S. firms with that of their international competitors. A survey of these studies was provided by Poterba (1991), who concluded that "Japanese firms have enjoyed a cost of capital advantage over their U.S. competitors throughout most of the last two decades, although the source of this advantage has shifted. At the beginning of the 1980's, for example, low costs of debt combined with debt-equity ratios substantially above those in the United States held down capital costs for Japanese firms... and today any cost of capital advantage is due to lower costs of equity rather than differential borrowing costs" (21).

Along the same vein, articles in the public press (e.g., Tsiang 1999, Northern Miner Staff 2011 and Orlik 2011) have proposed a similar explanation for the increasing competitiveness of Chinese firms. These articles cite the low cost of capital as an explanation for China's rapid growth over the past few decades. In addition to the cost of capital, Allen, Qian and Qian (2005) argue that the business practices of individual Chinese firms may be more efficient at producing growth than the practices pursued by U.S. firms. Thus, it is instructive to gain additional understanding of management practices in China, particularly how they may differ from practices in the United States. Because the cost of capital is such an important determinant of the competitiveness of a firm, it is critical to understand the methods that firms use to estimate and utilize the cost of capital.

Previous studies have surveyed firms in the U.S. (Gitman and Mercurio 1982; Bruner, Eades, Harris and Higgins 1998 and Gitman and Vandenberg 2000) and provided insights into the actual cost of capital practices utilized at the nation's leading firms. Given the importance of China in the world economy and its phenomenal growth over the past few decades, this paper surveys Chinese firms to assess their cost of capital practices and compares them to the best practices of the leading U.S. firms in the Gitman and Vandenberg (2000) study.

Methodology

Methodological congruency exists in that the survey utilized in Gitman and Vandenberg's study was used in this study of Chinese companies. However, the size of participating firms and the selection process of participants are expected to produce mild discrepancies between our study and the study conducted in 2000. Thus, the findings are not strictly comparable with those from the U.S. surveys of Gitman and Vandenberg. Nevertheless, we reproduce the results from the U.S. survey only to use as a standard for cost of capital estimation practices among some of the best firms. The survey results from the Chinese sample firms will be evaluated against the estimation practices of the U.S. sample firms. Despite this limitation, and given the difficulty in collecting data in China, our study provides useful insight into the cost of capital estimation experiences of 54 Chinese firms. …

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