Corporate Finance: Theory and Practice in China

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."