Corporate Finance: Theory and Practice in China
03/31/08 - 03:47 PM EDT
Knowledge @Wharton
"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 [they were] 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.
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