China‘s stock market has been on a roll. In 2006, all the indices of the Shanghai Stock Market Exchange and the Shenzhen Stock Market exchange doubled. In 2007, the main indices doubled again. These days, however, the market is trying to digest several companies’ financial behavior. In November 2007, China Oil, which had already been listed on the Hong Kong market, came back to issue A shares on the Shanghai Stock Exchange. The opening price was about 48 yuan ($6.70). Now it is below 24 yuan ($3.30). The Shanghai index has fallen from above 6000 to 4500, a 25% loss within three months. Last month, Pin An of China, a major insurance company, announced its 150 billion yuan (US$20.8 billion) financing plan, and the market responded by falling 7% in one day.


Li Yue, Xiong Dehua, Zhang Zheng and Liu Li, four faculty members at the Guanghua School of Management at Peking University, have led a research team from Peking University to explore the financial behavior of companies listed on China’s stock exchanges. Last November, the team published a paper titled, “Corporate Finance Theory and Practice: Evidence from China’s 167 Listed Companies” based on their findings. China Knowledge at Wharton recently interviewed Professor Li Yue and Zhang Zheng about their research.


The team sent out survey questionnaire forms through the mail or by fax to 1507 Chinese listed companies. The goal of the research was to better understand how Chinese companies behave when they make decisions about their capital budgets, the cost of capital and financing methods in the capital markets. Their research “can improve knowledge about the motivation behind financial decisions made by China’s listed companies,” says Zhang Zheng.


The researchers also studied the factors affecting these financial behaviors. “There have been only a few survey studies [done on] China’s corporate finance. One merit of our research is that the survey is performed independently by an academic institute rather than the government, which makes the results more reliable and meaningful,” says Li Yue. China’s capital market “is still immature. Most theories in corporate finance are based on mature economies. The research on a new market, such as China,” offers a unique contribution to this field of study, notes Zhang. 


Among the 1507 companies surveyed, 167 returned the forms. Among those 167 companies, 46 are from the manufacturing industry. The sample of non-manufacturing companies covers almost all kinds of business, including retail, wholesale, mining and construction, transportation, energy, real estate, communication and media, finance, medicine and high-tech. More than 50% of the sampled companies are large companies, with sales greater than one billion yuan (US$139million). For 85% of the sampled companies, the latest three-year average PE ratios are greater than 20. In terms of financial leverage, the rate of assets and liabilities range from 4.7% to 114%. In addition, 70% of the sampled companies are graded as AA or above. In terms of the type of controlling share holdings, 70% of the sampled companies are national holding, 24% are domestic private holding and 1.85% are foreign holding.


Listed Companies’ Long-term Investment Decisions


When asked: “What motivates you to consider a new investment project or a merger,” most companies answer: “the implementation of the company’s development strategy,” or “to increase the company size,” or “competitive strategy in the product market.” About 92% of respondents think that “the development strategy is important,” 74% say “increasing the size of the company is important,” and 75% think that “market competition is the motivation.”


The researchers also find that big companies put more emphasis on development strategy than smaller companies. The national holding companies are more interested in company size while companies from the manufacturing industry pay less attention to size, and more attention to their strategy for product competition.


Asked to compare the significance of different variables when making a decision on investments or mergers and acquisitions, most companies rank the following at the top: “expectation of sales on the product market,” “internal rate of return (IRR),” “higher than required return rate,” or “the net present value (NPV).” The result shows that China’s listed companies do care more about profit and other financial returns, termed as “rational” by economists. The higher leveraged companies pay more attention to the “flexibility” and “expansionary ability” of the project, implying that higher leveraged companies are cautious about potential financial problems caused by the failure of the project. The manufacturing companies put more emphasis on sales expectation and market share rather than financial variables such as NPV and return rate, showing that most manufacturing companies face the pressure of market competition.


How to Calculate the Capital Cost


The researchers focus on three questions: How companies estimate capital costs, how they choose the discount factor for an investment project and how they judge the risk elements.


The survey results show that 52% of the sampled companies think equity financing is less costly than debt financing. The result confirms the impression that Chinese companies prefer equity financing. Li and his colleagues find that “the historical average return rate on the stock market” and “the loan interest rate of the bank” are the two most important components Chinese companies use to estimate the cost of equity capital.

Most Chinese companies do not care about the Capital Asset Pricing Model (CAPM), the standard method used by companies in western countries to estimate the cost of equity capital. Only a small portion of sampled companies (24%) use CAPM. A possible explanation could be that China’s stock market is still far from mature. The stock price does not reflect the real value of the equity because of the difference between the untradable state-owned shares and ordinary shares held by the public.


The researchers find that Chinese listed companies may not have a consistent logic when they pick the discount rate for a particular investment project. When answering the question, “how often does your company pick the following variable as the discount factor to evaluate a new project,” most companies simultaneously choose three variables: “the bank loan interest rate,” “the discount factor of the industry” and “the particular discount rate that matches the project’s risk.”


“It seems that most Chinese CEOs do not have a clear idea about the difference between the three variables,” says Li. “They ignore the shortcomings of the first two. So we think they don’t fully understand the capital cost.” In their paper, Li and his colleagues argue that the relatively low bank loan interest rate could underestimate the cost of the project and may even lead to investing in a negative NPV (net present value) project. Using the discount factor of the industry is an improvement. However, the ideal discount factor should be the third one, based on the equity, debt and the risk character of the company. “From the point of view of the market, picking a false discount factor could cause the low efficiency of the capital allocation, and consequently hold back China’s economic growth,” says Li.


According to the report, when judging the risk of an investment project, Chinese companies consider the interest risk, the price risk, the interest term structure risk, the GDP or cyclic business sentiment risk, and so on. However, few of them will consider the inflation risk or the risk of financial distress. Ignorance of the risk of financial distress could be the reason that many listed companies make unwise investments.


Why do Chinese companies ignore the risk of financial distress? “One relevant issue could be corporate governance,” says Li. “Because of the huge amount of state-owned shares, the person who makes the financial decision may not be fully responsible for the financial outcome. Meanwhile, the monitoring of state-owned shares is weak. So insiders have a lot of opportunities to ignore the risk. Another reason could be the long-time low interest rate and inflation rate. Companies just don’t think inflation is a big deal at the time being surveyed.”


Financial Behavior and the Choice of Capital Structure


Among all the financing methods, the companies see “short-term borrowing” as the most important. The second most important is the “issuing of new shares.” The next one is “retained profits.” The least important financing method for Chinese companies is “corporate bonds.” The heavy dependence on short-term borrowing implies that there are huge short-term loans in circulation. The result also shows that China’s capital market plays an insufficient role in providing the long-term loanable funds to its companies. The emphasis on “issuing new shares” is consistent with Chinese companies’ preference for equity financing.


Unlike U.S. companies, the chairman of a Chinese company plays a more important role than the CEO when making financing decisions.


Interestingly, most companies think that “the whole society’s knowledge of financial markets and financial instruments” is very important when it comes to making financial decisions, even more important than the CEO of the company.


When making decisions on equity financing, the most important factor becomes “whether the company is eligible for equity financing.” In addition, “the policies regarding re-financing by the China Securities Regulatory Commission” also play a very important role in companies’ equity financing decisions. It shows that the company’s re-financing behavior is mainly determined by these policies and whether the company satisfies the requirements, rather than the company’s need for money.


Besides regulation and policy, another important issue for listed companies considering equity financing is “to introduce the strategic investors, to improve the corporate governance structure and to absorb the new idea or technology.”


On the topic of debt financing, the report shows that the factors that affect a company’s choice of debt include profitability and cash flow fluctuation, credit grade, the transaction cost and fee of debt financing, the tax shield effect of the interest expense and the possibility of the financial distress caused by debts. “The good news is that companies do consider their solvency and ability to obtain money. However, ignoring the possibility of financial distress, meanwhile, seduces the companies into over borrowing and over investment. The survey shows that policy and institutional constraint play an important role in the debt financing in China,” comments Zhang.


Do China’s listed companies choose financing options based on stock market prices? The research says no. The result of the survey shows that “the possibility of issuing stock with a high price because of recent price increases in the company’s stock” is not a big concern of the company when making a decision on issuing new shares. Also, “the under-evaluation of the stock price” is not the reason for the company to issue the convertible bonds. “Convertible bonds are a means of delaying an issue. However, unlike the companies in western countries that delay an issue because the current stock price is under-priced, Chinese companies delay an issue to get around the government’s requirements that the company currently cannot satisfy,” says Li. As mentioned earlier, the issuing behavior of China’s listed companies is mainly determined by policy and whether the company satisfies requirements set by regulators.


Do Li and Zhang think China’s listed companies’ financing behavior protects the shareholders’ interest? “American companies care more about shareholders’ interests, while Japanese and German companies care more about the relevant stakeholders — including employees, managers, the community and the environment,” the two researchers note. “As for China’s listed companies, it’s not consistent yet and it’s in a transforming process. Initially, the company was protecting the interests of the insiders and the majority shareholders. Now it cares more about all shareholders. In the future, will it put more emphasis on the relevant stakeholders? We don’t exclude such a possibility.”