6

The determinants of capital structure1

Introduction

The idea that the general characteristics of a firm's capital structure can affect its performance has been receiving increasing attention from the financial profession. Modigliani and Miller's (MM) classic 1958 paper demonstrated that the value of a firm with given cash flows was not affected by its debt-equity ratio, in a perfect market where there are no friction costs, bankruptcy costs, and taxes. However, extensions to their analysis, incorporating variables such as taxes, bankruptcy costs, and agency costs indicate that the mix of financial claims affects the value of the firm because changes in the mix change the firm's total cash flows. With the increasing interest in corporate governance issues, the link between corporate governance and capital structure has been attracting considerable theoretical attention. 2

This chapter investigates the determinants of capital structure in Chinese firms, and will contribute to our understanding of the corporate governance mechanism in China. Although there have been many studies of capital structure for developed and developing countries alike, this is the first such study for China. Furthermore, this study combines insights from various strands of finance theory, notably agency theory, signalling theory, and the theory of corporate control to establish a more comprehensive model of the determinants of capital structure.

This study will also contribute to the increasing number of empirical studies from around the world, and fills a gap in the case of Chinese listed companies. The prevailing view, as expressed by authors such as Mayer (1990) and Rajan and Zingales (1995), and as commented upon by Booth et al. (2001), seems to be that financial decisions in developing countries are made somewhat differently from that predicted by the standard theories derived from developed economies. Booth et al. (2001) carried out a detailed study of ten developing countries, and showed that the determinants of capital structure are largely consistent with those in developed countries. This study will test the stylised facts we have learned from both developed and developing economies, and add new evidence on the determinants of capital structure in transitional economies such as China in which factors such as the taxation, accounting, banking, and governance systems are rather different from the countries already studied.

The structure of the chapter is as follows. In the next section, we outline the theory of capital structure, beginning with the classic MM paper and then discussing

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Corporate Governance in China
Table of contents

Table of contents

  • Title Page iii
  • Contents vii
  • Figures x
  • Tables xi
  • Preface xiii
  • Acknowledgements xiv
  • Abbreviations xv
  • 1 - Introduction 1
  • 2 - Theoretical Approaches to Corporate Governance 10
  • 3 - The Evolution of Corporate Governance in China 31
  • 4 - The Effect of Ownership Structure on the Underpricing of Initial Public Offerings 62
  • 5 - Ownership Structure as a Corporate Governance Mechanism 88
  • 6 - The Determinants of Capital Structure 105
  • 7 - Chinese Corporate Groups 123
  • 8 - General Conclusions and Future Work 146
  • Notes 153
  • References 157
  • Index 170
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