FINANCIAL STRUCTURE

THE FINANCE IS THE LIFE BLOOD OF ANY ORGANIZATION SO THE SOURCES USED FOR
ALL OPERATIONS OF ORGANIZATION COLLECTIVELY CALLED FINANCIAL STRUCTURE. In
other words financial structure is the mix of all sources of financing used by the firm.
The optimal or target capital structure is that debt/equity mix that (1) maximize the value of the firm. (2)
Minimize the weighted average cost of capital (3) maximize the market value of common stock. Optimal
capital structure for a company refers to the composition of debt and equity, where the firm cost of capital
is the lowest and value of the firm the highest. Optimal capital structure for one company cannot be same
for the other company as well as the firms differ from each other in their basic characteristics. Even if the
firms have same basic characteristics, they differ in Human resource, skill set etc.
MMT (MILLER AND MODIGILLANI (1958))
They have presented the theory of determinants of corporate capital structure in 1958. Their main theory
explains the value of the firm is unaffected how the firm is financed. This theory said that the capital
structure hold no importance or relevance to the company value of money. So the theory is also known
capital structure irrelevance principle. They hypothesized that in perfect markets, it does not matter what
capital structure a company uses to finance its operations. They theorized that the market value of a firm is
determined by its earning power and by the risk of its underlying assets, and that its value is independent
of
the
way
it
chooses
to
finance
its
investments
or
distribute
dividends.
The Miller-Modigliani Theorem
In an environment, where there are no taxes, default risk or agency costs, capital structure is
irrelevant.
The value of a firm is independent of its debt ratio.
Implications of MM Theorem
Leverage is irrelevant. A firm's value will be determined by its project cash flows.
The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the
cost of equity will increase just enough to offset any gains to the leverage.
Main Theories of capital structure
Packing order theory
Asymmetric information exists and it is costly. Managers have more information about the quality of the
firm. Companies select financing according to the law of least effort.
(1) Internal financing (retained earnings), first.
(2) Bank debt (in different levels, easiest: bank debt) , second
(3) Equity, last resort.
The Tradeoff Theory of Leverage

The tradeoff theory assumes that there are benefits to leverage within a capital structure until the optimal
capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest,
however, that most companies have less leverage than this theory would suggest is optimal.
In comparing the two theories, the main difference between them is the potential benefit from debt in a
capital structure. This benefit comes from tax benefit of the interest payments. Since the MM capitalstructure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the trade-off theory
of leverage, where taxes and thus the tax benefit of interest payments are recognized.
What motivated the author to study the topic (DETERMINANTS OF CAPITAL STRUCTURE OF
CHINESE LITSTED COMPANIES?)
Since the last 40 years researchers and academia focused to provide empirical evidence whether
1- The theoretical models have explanatory power when applied to real business world.
2- During this period main focus remained to understand forces that influenced corporate finance
behavior of developed nations
3- Recently capital structure research has become internationalized and opened the doors for
researchers to make cross sectional comparison between countries and various industries.
Majority of research work has been done for developed economies which have institutional similarities.
And a little work has been done to further the knowledge of capital structure within developing countries.
FOCUS OF THE STUDY
This study focus on whether
a. The firm specific factors of western setting similarly correlated in China.
b. The institutional structure of China effects capital choice decision of Chinese listed companies.
c. The western capital structure model has strong explanatory power for Chinese companies in Chinese
economy.
Methodology
Data was taken from the Dow China 88 index based on entire Chinese stock market for the period of 19952000. Financial statements of these firms were prepared following the U.S. GAAP
Sample represents the aggregate leverage of country because the listed companies represent the driving
industrial force of China. Excluded financial sector firms and also those firms having missing data
variables. Finally 77 firms over a period of six years consists of balance Panels were taken
Dependent variables
Overall leverage (LEV): Ratio of book value of total debt to total assets and
Long-term leverage (LLEV): Ratio of book value of long term debt to total assets
Independent variables
Profitability (PROF) Ratio of earnings before interest, tax, and depreciation to total assets
Size (SIZE) Logarithm of total assets
Growth opportunities (GROWTA and GROWNO): Sales growth/total asset growth (due to the absence of

R&D and advertising expenditure data)

Asset
structure (TANG) Tangibility: ratio of tangible assets (the sum of fixed assets and inventories) to total
assets
Cost of
financial distress (EVOL) Earning volatility: absolute value of the first difference of percentage change of
operating income
Tax shields
effects (NDTS) Non debt tax shields: ratio of depreciation to total assets (due to depreciation is the most
significant element among non debt tax shield)
a.
b.
c.
d.

There is negative relationship between profitability and debt;

A positive relationship exist between growth opportunity and debt;
There is a positive relationship between tangibility and debt;
A negative relation exists between a firms size and long term debt.

Results conclusion and justification of results

Certain firm specific factors which are relevant to explain the capital structure in developed
countries are also relevant In China. Reason is that Chinese listed firms have followed basic rules
of market economy despite the state controlling.
Neither the packing order model nor the trade off provides the convincing explanation for the
choice of capital structure in Chinese firms. Reason is that Fundamental institutional assumptions
of developed countries are not valid in China.
Chinese firms seem to follow the new packing order that is Retained earnings, Equity, and Debts
as last resorts.

Chinese firm prefer short term finance and lower of long term debt. So theories of capital structure
explanatory power might limit in China.

Significant institutional differences and financial constraints in banking sector in China are the
factors influencing leverage decision and these are at least as important as the firm specific factors.

These finding reflect the transitional nature of Chinese corporate environment. Further this is also
because of the fact Chinese environment still hold some features of command economy. The state
is still principal stakeholder of firms and owns banks, as well as the beneficiary of tax.