EffectsofcorporategovernanceoncapitalstructurechoiceofChineselistedfirms.docx

Waikato Management School
Corporate Finance
ZUCC-joint International Programme

Effects of corporate governance on capital structure choice of Chinese listed firms

English full Name & Student ID: Gloria Chen 31205611
Pie Shan 31205614
Breathe Yang 31205590
Charis Ying 31205592
Judy Yi 31205591
Doris Wang 31205627

Assignment: Introduction and Literature review
Date Submitted 23rd March
Official Use Only
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Word Count 2452

Effects of corporate governance on capital structure choice of Chinese listed firms
Introduction
Corporate governance is a collective issue suggesting “organize, manage, lead and control the overall operation in a company for sustainable development and growth” (Masnoon & Rauf, 2013). Specifically, effective corporate governance is significantly essential for a company to construct its capital structure for investment purpose and acquire considerable returns for its shareholders. Moreover, several attributes of corporate governance, including board size, outside directors, ownership concentration, managerial ownership, director remuneration and CEO duality, influence company’s ability in attracting capital and reducing debt cost a lot.

A great number of researchers examined the relationship between corporate governance and capital structure in their own countries. However, the empirical research about the impact of corporate governance on the capital structure choice of Chinese listed companies is rare. As a result, it is critical to examine how the corporate governance influences the choice of capital structure in China. This paper examines the relationship between various variables of corporate governance and the capital structure of Chinese listed firms during 2005 to 2014.

The remainder of the paper is organized as follows: the next section provides brief backgrounds of corporate governance and capital structure in China and an overview literature on the subject matter. The following section discusses data, variables and methodology. Then, the paper presents the research results and discussion. Finally, the last section draws a conclusion.

Overview of literature

The literature on international trend of corporate governance has gone through an explosive growth in the past decades (Li, Xu, Niu&Qiu, 2012). As the strongest developing country, which has experienced typical emerging economy, China is transforming from administrative governance to economic governance in aspect of corporate governance (Li, Xu, Niu&Qiu, 2012). Regarding to corporate governance of listed firms im China, from the moment that equity markets established in 1990, the Chinese state council and the China Sexurities Regulatory Commission (CSRC) have concentrate a lot in advancing the corporate governance of listed firms (Yang, Chi and Young, 2011). For the reason that there have been lots of fraud cases related to capital structure. For example, New York Stock Exchange-listed Longtop Financial (LFT), which is a financial software company having multi-billion dollar market capitalization, however, was accused by American short seller of inflating its margin through hiding operating costs (Jackson, 2011). The accuse hit the company severely, and meanwhile put great pressure on Chinese corporations as well. Therefore, for the purpose of regulate the market, several laws and codes relating to corporate governance have been established (Yang, Chi and Young, 2011). For instance, the non-tradable share reform introduced in 2005 has impacted listed firms’ corporate value and performance positively. However, because of Chinese complicated environment, governance instruments which are efficient in developed countries do not work equally well in China. Therefore, Sheikh and Wang (2012) further state that to reduce the rate of fraud, it is inevitably to enhance accountability and efficiency. Apart from that, since corporate governance is bounded with corporate capital structure as well, optimize the capital structure is another choice. In China, as Wang (2003) demonstrates, corporations are more likely to have lower leverage level compared to other countries. Take real estate companies for example, because of the undeveloped corporate bond market and the ownership structure, they tend to have lower long-term debt ratio and higher equity over fixed assets ratio. Consequently, it is significant to the company whether managers act in the common interest with stockholders. Aspects that play essential role and are needed to be researched including board size, outside directors, qualification of directors, CEO duality, functions of board of directors, and financial reporting framework.

Measures of corporate governance and their relation to capital structure
A number of empirical studies have illustrated that board size, outside directors, ownership concentration, managerial ownership, managerial compensation and CEO duality will have influence on corporate governance. Moreover, a specific discussion of these attributes and their relation to capital structure is clarified below.

Board size

The board of a corporate plays vital roles in decision-making process. The board determines the overall strategy and policy involving various aspects of corporate governance. Specifically, one of the most essential issues is the construction of capital structure. Moreover, the relationship between board size and capital financing has raised much attention. According to Wen et al. (2002) and Abor (2007), the financial leverage (capital structure) is positively related with board size, suggesting that larger board tends to pursue higher leverage for higher company valve. Additionally, they also claimed that the difficulty in arriving agreement resulted from lager board size can weaken corporate governance, which leads to high leverage. Similarly, Anderson et al. (2004), Kyereboah-Coleman and Biekpe (2006) have shown a positive association between board and debt ratio. Specifically, Anderson has shown a negative relationship between board size and cost of debt financing, suggesting that companies benefit from larger boards with pool of expertise and resources, which promotes them to adopt high debt policy. However, according to Lorca, Sanchez-Ballesta & Garcia-Meca (2011), there is a non-linear relationship between board size and cost of debt, since the benefits can be partly offset by less efficient communication and decision-making, which results in larger cost of debt financing. Hence, the relationship between board size and capital structure is insignificant. Conversely, Merhan (1992), Berger et al. (1997), Abor and Bikpie (2005), and Hassan and Butt (2009) illustrated that larger boards prefer lower debt levels, since larger boards emphasize the importance of “owner-manager”, which prefer equity capital to improve corporate performance.

Outside directors

The directors in the company can be divided into two parts: outside directors and inside directors. The major difference between the two parts is that outside directors are independent from the company which means they comes from outside of the company and do not participate in daily regulation. Although the two types of directors have distinct functions for the company, it is frequently discussed whether the high degree of board independence is positive for the company and its capital structure.

A significant reason for forming outside directors is that it improves company performance since they can better protect the benefit of shareholders. Outside directors have been shown to strongly resist certain actions that may have benefited corporate executives at the expense of shareholders (Ness, Miesing, & Kang, 2010).
Moreover, Li and Tan (2010) confirm that “the proportion of independent directors on the board is negatively associated with earnings management” which provides the evidence that independent directors are beneficial for board’s effectiveness when monitoring financial reporting. Li and Tan (2010) also fund that leverage (LEV) is positively associated with earnings management.

Additionally, the relationship between the degree of board independence and cost of debt should be determined by different situation. It can be concluded from Bradley and Chen’s report that outside directors consider more about shareholders’ benefits which may result in higher cost for bondholders. Due to the different extent of interest conflict between shareholders and bondholders, there would be diverse impact of independence on cost of debt. Bradley and Chen (2014) stated that “While board independence significantly reduces the cost of debt when the B/S conflict is mild, it substantially increases the cost of debt when the conflict is severe”.

Ownership concentration

External block shareholders are argued to mitigate agency problems between management and shareholders, because it lowers the scope of managerial opportunism (Shleifer and Vishny, 1986). In general, block shareholders have more power than diffused shareholders to influence the manager’s decision. And they often have incentive to monitor and influence management, because their interest is connected with the company’s profit (Friend and Lang, 1988). Therefore, block shareholders may force the management to take several actions to maximize their interest. For example, if fund is required for capital investment, block shareholders probably force management to use more debt because interest on debt is tax deductible, which results in lower cost than equity-financing (Megginson and Smart, 2010). Moreover, naturally block shareholders will be more in favor of establishing and continuing such capital structure which makes their ownership right of control over management. Consequently, they are more likely to drive management to use more debt as debt normally does not have voting or control right until principal and interest are worked as a debt covenant (Ganguli, 2013). These explanations suggest a positive relationship between block shareholders and leverage. Ganguli (2013) mentions that the leverage has a positive relation to concentrated shareholding and is negatively related to dispersed shareholders. Brailsford, Oliver and Pua (2002) also find that there is positive linear relation between external block shareholders and leverage, and the relation between them varies across the level of managerial share ownership.

Managerial compensation

Bonus, stock option, as well as increased wages are included in managerial compensation. A desirable managerial compensation both attracts talents and reduce turnover. However, an insufficient managerial compensation may leads to overinvestment regarding to capital structure.
An underpayment probably induce a manager overinvest for the reason that overinvestment could gain more profit for managers themselves, while shareholders do not benefit from it (Lei, Chao, Wang & Yu, 2014). According to Xu and Birge (2008), this is called agency problem, which not only make the equityholders’ wealth decreased, but also increase agency costs. Therefore, not enough managerial compensation could motivate managers to take more risk, and directly influence the capital structure through increasing debt ratio. For the purpose of alleviate agency problem, organizations establish compensation package to stimulate managers to make decisions that could raise the wealth of shareholders (Wang, 2012). It is estimated that pay-performance sensitivity is important according to statistics ( Jesen & Murphy, 1990). Moreover, there is a positive connection between top CEO pay and returns to shareholders. Another kind of mechanism established by organizations is called equity-based compensation (Hwang, Kim & Pae, 2014). Hwang, Kim and Pae (2014) further states that the proportion of equity-based compensation for outside directors negatively associate with the cost of equity capital which eventually could manipulate managers act in stockholder’s best interests. However, situations are not always the same. In Malaysian distressed firms, Abdullah (2006) found a considerable negative association between return on assets and director remuneration. Another study implemented by John and John (1933) represent that there is negative relationship between top management compensation and capital structure. Therefore, as stated by Berkovitch, Israel and Spiegel (2000) ：“connection between managerial compensation and capital structure is systematic and complex. ”

Managerial ownership

Managerial ownership means the ratio of shares held by CEOs, directors and their immediate family members to total outstanding shares which is important to the firm value and capital structure (Huang & Song, 2006). Since the agency problem which means the conflict of interest between shareholders and managers can reduce the firm value, it is necessary to adopt a befitting level of managerial ownership to avoid the agency problem (Ruan, Tian & Ma, 2009). According to Ruan, Tian and Ma (2009), only with a relatively high level of managerial ownership, the agency problem can be mitigated largely, the agency cost can be reduced and firm value can be maximized. Moreover, Ruan, Tian & Ma (2011) found that a negative relationship exists between managerial ownership and debt ratio. Although a low level of managerial ownership can help connect interests of insiders and shareholders and make better decision making, it can arise problems. As managers acquire the share of firm, they can get voting power and can influence decision making; they can utilize the debt ratio to increase self-interests (Ruan, Tian & Ma, 2011). However, as the level of managerial shareholding increase to a considerable high level, it can make the interest of managers aligned with shareholders and can reduce the entrenchment effect. Therefore, the debt ratio can be reduced because the agency-related benefits of using debt decreased and managers intend to avoid bankruptcy risks (Bruslerie & Latrous, 2012).

Managerial ownership is an important factor to the choice of capital structure. Bruslerie and Latrous (2012) found a negative relationship between low level managerial ownership and leverage and a positive relationship between high level managerial ownership and leverage. Ruan, Tian & Ma (2011) stated that the managers increase the debt ratio in order to strengthen their control mainly to control a large fraction of voting rights. Novaes and Zingales (1995) stated that the threat of a takeover forces the managers to issue debts and to prove their alignment. However, Friend and Hasbrouck (1988) indicated that an increase in managerial ownership pushes firms to reduce leverage in order to decrease default risk thereby advocating a negative relationship between managerial ownership and leverage.

CEO duality

CEO and chai