Equity financing capacity and stock returns: Evidence from China

Equity financing capacity and stock returns: Evidence from China

Int. Fin. Markets, Inst. and Money 22 (2012) 1277–1291 Contents lists available at SciVerse ScienceDirect Journal of International Financial Markets...

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Int. Fin. Markets, Inst. and Money 22 (2012) 1277–1291

Contents lists available at SciVerse ScienceDirect

Journal of International Financial Markets, Institutions & Money j o ur na l ho me pa ge : w w w . e l s e v i e r . c o m / l o c a t e / i n t f i n

Equity financing capacity and stock returns: Evidence from China夽 M.M. Fonseka a, Lalith P. Samarakoon b,∗, Gao-Liang Tian a a Department of Accounting and Finance, School of Management, Xi’an Jiaotong University, No. 28, Xianning West Road, Xi’an, 710049, Shaanxi, PR China b Department of Finance, Opus College of Business, University of St. Thomas, 2115 Summit Avenue, St. Paul, MN 55105, United States

a r t i c l e

i n f o

Article history: Received 28 May 2012 Accepted 26 July 2012 Available online 13 August 2012 Keywords: Equity financing capacity Stock returns Rights offers Public offers China

a b s t r a c t We examine the relation between the capacity for financing through rights and seasoned public offers of equity and subsequent stock returns in China. The results show that the capacity for rights and public offers is reliably negatively related with future returns for firms that met regulatory criteria. Further, the capacity for rights offers is strongly negatively related with returns for firms that met the criteria and applied for approval, and for firms that issued equity after meeting the criteria and obtaining approval. Thus, there is clear evidence of a negative relation between equity financing capacity and stock returns in China. © 2012 Elsevier B.V. All rights reserved.

1. Introduction There is a large body of literature on the relation between equity financing and stock returns. These studies focus on the actual financing activities such as the issuance of equity and debt. However, there is very little research on the relation between the capacity of a firm to raise external funds and stock returns. China provides a unique setting for studying the stock market valuation of equity financing capacity because the listed firms in China have to meet specific requirements set by China

夽 Authors wish to thank the participants of the 2011 Symposium of China Journal of Accounting Research, the 2011 Symposium on Empirical Accounting Research in China, and the 2012 Global Finance Conference for useful comments. We also thank the editor and two anonymous referees for useful comments. ∗ Corresponding author.

E-mail addresses: [email protected] (M.M. Fonseka), [email protected] (L.P. Samarakoon), [email protected] (G.-L. Tian). 1042-4431/$ – see front matter © 2012 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.intfin.2012.07.004

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Securities Regulatory Commission (CSRC) to become eligible to issue equity and debt securities. The CSRC effectively defines a firm’s capacity to issue equity and debt. We examine whether the equity financing capacity, defined as the eligibility to raise external equity capital through rights and seasoned public offers as per CSRC regulations, is related to future stock returns.1 Our paper is uniquely different from previous research on financing and stock returns in that we focus on the impact of the capacity to raise equity funds rather than the relation between actual financing activities and stock returns. From the standpoint of neoclassical investment theories, the ability to raise equity capital provides the firm with financing flexibility and enables it to exploit any emerging profitable investment opportunities that will lead to future cash flow growth and increased shareholder wealth. Investors recognize the possibility of profitable investments and growth, leading to higher expected returns. Thus, neoclassical investment theories predict a positive relation between capacity to raise equity and future returns. On the other hand, agency, signaling, and earnings-management explanations predict a negative relation between equity financing and returns. Agency conflicts between managers and shareholders may lead to the overinvestment problem, which is investing in unprofitable projects resulting in negative NPV and loss of shareholder wealth (Jensen, 1986; Jensen and Meckling, 1976). When firms issue equity, the market recognizes this overinvestment problem by way of lower expected returns. The signaling hypothesis posits that firms issue equity when they are overvalued, and market prices adjust downward subsequently leading to a negative relation between equity issuance and stock returns (Myers and Majluf, 1984; Loughran and Ritter, 1995, 1997, 2000; Ritter, 2003). Earnings management explanations argue that firms intending to issue equity opportunistically manage their earnings to alter financing proceeds in their favor (Cohen and Lys, 2006; Dechow et al., 2008; Papanastasopoulos et al., 2008). When investors recognize earnings management, the price drops subsequently. The key implication for firms that have not yet issued equity but have the capacity to do so is that the market recognizes the propensity for these firms to issue equity and over-invest, issue overvalued equity, or engage in earnings management activities leading to lower expected returns. Therefore, the capacity to issue equity capital will be negatively related with future stock returns. We contribute to the literature in a number of ways. We examine the relation between equity financing capacity and stock returns, which has received very little attention in the empirical finance literature. More importantly, our study is based on a unique setting where the capacity to issue equity and debt to the public by firms listed in China is determined by the Chinese securities market regulation. The requirements for becoming eligible to raise external capital essentially creates two types of firms – those eligible to raise external capital and hence have external financial capability and those that are not eligible and hence have constrained external financing. We specifically examine whether the capacity to make rights and seasoned public offers of equity is priced in the market in terms of future returns. Due to the tight controls and regulations related to access to public capital markets in China, only a portion of listed firms qualify to access public equity and debt markets in China. The capacity to raise external capital is an important intangible option available to the firm and could conceivably affect stock returns. We are able to enrich the existing literature on financing behavior and stock returns by showing how equity financing capacity is related to stock returns in a highly regulated emerging capital market. The scope of this study is limited to examining how equity financing capacity is related to future returns. A related and important issue is the factors such as earnings management that may explain the relation between equity financing capacity and returns. That issue is beyond the scope of our present study and points to a further research area. The results of our study show that the capacity for rights offers of shares is strongly negatively related with future stock returns. This negative relation between capacity to make rights issues and future stock returns is the strongest for firms that met the regulatory criteria a priori and then applied for regulatory approval. This finding is particularly important in that rights offers have been the most dominant form of equity financing by listed firms in China. We also find that although the capacity for seasoned public offers of equity is reliably negatively related with future returns for firms that qualified

1

We do not study issuance of debt securities because debt issues by listed firms are not very common in China.

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to issue shares to the public based on regulatory criteria, such evidence does not hold up for firms that applied for regulatory approval for public issues or made public issues. We also investigate the subset of firms that in fact issued equity after obtaining regulatory approval and find even a stronger negative relation between the capacity to issue equity through rights and future stock returns. Thus, we show clear and strong evidence of a negative relation between rights offering capacity and stock returns in China. These findings are consistent with agency, signaling as well as earnings-management hypotheses which predict a negative relation between equity issuance and subsequent returns. The existing U.S. evidence on the relation between actual equity issuance and stock returns shows significant stock price underperformance subsequent to seasoned equity offerings (for example, Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995). Consistent with this prior evidence, our study contributes to the literature by showing that even the capacity to issue equity is negatively related with returns. The reminder paper is organized as follows: Section 2 provides a description of the Chinese regulatory requirements for equity issuance. In Section 3, we present data and the empirical research design, while Section 4 provides the empirical results. Finally, Section 5 provides a summary and conclusions.

2. Chinese regulatory requirements for equity financing The issuance of securities in China is regulated by China Securities Regulatory Commission. The regulatory requirements are primarily determined by accounting-based quantitative and qualitative criteria. The basic quantitative criterion is that a firm must have met a minimum profitability threshold during a defined period. A detailed listing of the historical evolution of the criteria is given in Table 1. Before 2000, the only permitted method for raising equity by firms listed in China was rights offers made to existing shareholders on a pro-rata basis at a price below-market price. In the 1990s, due to the high demand for shares from the investing public in China, rights issues were fully subscribed by shareholders. The CSRC issued first guidelines on right issues by listed firms in 1993 requiring that firms must have been profitable in the previous two years. In 1994, the regulation was tightened by requiring three years of profitability and a minimum three-year average ROE of 10%. Further tightening of the criteria to a minimum three-year average ROE of 10% and a minimum ROE of 6% in each of the previous three years significantly reduced the number of firms meeting the requirements for rights issues. The profitability requirement has been relaxed gradually over the years, and since 2006 the profitability requirement is that the ROE should be greater than zero. As Table 1 shows, during the sample period of 2000–2009, there have been three regulatory regimes relating to right issues. Listed companies in China were not permitted to make seasoned equity offers until 2000, when the CSRC allowed companies with profits in each of the previous three years to apply for permission to issue shares to the public. This regulation was much less stringent than the then prevailing criteria for approving rights issues, and as a result a large number of firms announced public offers of equity. In 2001, this criterion was tightened and made consistent with the condition for right offers by requiring that the three-year average ROE be at least 6%, and in 2002 the eligibility for public offers of equity was further restricted with the condition that the three-year average ROE as well as the ROE in the previous year be at least 10%. But the last revision in 2006 relaxed the profitability requirement to a minimum three-year average ROE of 6%. Thus, during our sample period there were four regulatory regimes governing the eligibility to apply for permission to make public offers of equity.

3. Research design 3.1. Description of data and sample The sample includes all non-financial companies listed in China and contained in the China Stock Market and Accounting Research (CSMAR) database during the 10-year period from 2000 to 2009. We use China Listed Firms’ Seasonal Equity Offering Database, China Listed Firms’ Cash and Stock Dividends Research Database, and Stock Market Financial Statements Database in the CSMAR data

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Table 1 CSRC requirements for determining eligibility to apply for securities issuance. Date

Rights offers

Public offers

1993/11/17

2 years of profitability.

Not permitted.

1994/10/30

3 years of profitability and 3-year average ROE ≥ 10%. ROE ≥ 10% in each of the previous 3 years.

Not permitted.

• 3-year average ROE ≥ 10% and ROE ≥ 6% in each of the previous 3 years. • The gap between two consecutive equity issues must be over one year, and the previous issue has been fully subscribed. • No material omission, misrepresentation in financial reporting and falsification of financial accounts over the last 3 years. • No violations of securities law and regulations over the previous 3 years. • No harmful related-party transactions with controlling shareholders.

Not permitted.

1996/01/24 1999/03/17

• ROE ≥ 0% in each of the previous 3 years. • The gap between two consecutive equity issues must be over a year, and the previous issue has been fully subscribed. • No material omission, misrepresentation in financial reporting and falsification of financial account over the last 3 years. • No harmful related-party transactions with controlling shareholders.

2000/04/30

2001/03/15

2002/07/24

Not permitted.

• 3-year average ROE ≥ 6% • The gap between two consecutive equity issues must be over one year, and the previous issue has been fully subscribed. • No material omission, misrepresentation in financial reporting and falsification of financial accounts over the last 3 years. • No violations of securities law and regulations over the previous 3 years. • No harmful related-party transactions with controlling shareholders.

• 3-year average ROE ≥ 6%. • No harmful related-party transactions with controlling shareholders. • No material omission, misrepresentation in financial reporting and falsification of financial account over the last 3 years. • No violations of securities law and regulations over the previous 3 years.

• 3-year average ROE ≥ 10% and ROE ≥ 10% in the previous year. • No harmful related-party transactions with controlling shareholders. • No material omission, misrepresentation in financial reporting and falsification of financial accounts over the last 3 years. • No violations of securities law and regulations over the previous 3 years. • The total value of the issue is less the book value of equity at the end of last year. • Assets–liability ratio of the year before issuance is not less than the average level of listed firms in the same industry. • The issuing firm and its directors had not been punishment by the CSRC or publicly reprimanded by the stock exchange over the last year. • If the company wishes to issue more than 20% of existing issued capital, company would get an approval of 50% of non-trading shareholders.

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Table 1 (Continued) 2006/05/08

• ROE ≥ 0% in each of the previous 3 years. • No current director, supervisors or executive was punished by the CSRC over the last 3 years or publicly reprimanded by the stock exchange over the last 1 year. • No guarantees, litigation, arbitration or other significant matters which seriously affect the company’s continuous operations. • Operating earnings has not declined by more than 50% in this issuance year, if the firm had an issuance (including both equity and bond issuing) over the last 2 years. • No qualified, adverse or disclaimer opinion in audit reports over the previous 3 years. • Total cash or stock dividends in the last 3 years are more than 20% of the average net distributable earnings of the previous 3 years. • No material omission, misrepresentation in financial reporting and falsification of financial accounts over the last 3 years. • No violations of securities law and regulations over the previous 3 years. • The issuing firm had not been publicly reprimanded by the exchange over the previous year.

• 3-year average ROE ≥ 6%. • No current director, supervisors or executive was punished by the CSRC over the past 3 years or publicly reprimanded by the stock exchange over the last year. • No guarantees, litigation, arbitration or other significant matters which seriously affect continuous operations of the company. • Operating earnings has not declined by more than 50% in last issuance year, if the firm had an issuance (including both equity and bond issuing) over the last 2 years. • No qualified, adverse or disclaimer opinion in audit reports over the previous 3 years. • Total cash or stock dividends in the last 3 years are more than 20% of the average net distributable earnings of the last 3 years. • No material omission, misrepresentation in financial reporting and falsification of financial accounts over the last 3 years. • No violations of securities law and regulations over the last 3 years. • The issuance firm had not been publicly reprimanded by the stock exchange over the previous year.

Source: China Securities Regulatory Commission.

series.2 All firms selected represent A-share companies. We require that a firm must have appeared in this database for at least two years. Both foreign-listed Chinese companies and Chinese companies dual-listed in Hong Kong are excluded from the sample. We also exclude firms for which the necessary financial and other data are missing. Information relating to application for and approval of rights and seasoned public share issues are obtained from CSRC.3 The final sample is an unbalanced panel dataset consisting of 10,705 firm-year observations representing 1563 firms. Table 2 shows the number of observations and the number of firms in the total sample and its breakdown into sub-samples based on whether a firm qualified, applied, or issued rights and public offers. The companies that meet the requirements of the CSRC for rights and public offers of equity are considered as qualified firms. The qualified firms that made an application to the CSRC are categorized as qualified and applied firms. The number of qualified firms that applied for approval to make equity issues was about 4% and 3% for rights and public offers respectively. Interestingly, we found that some firms that did not qualify as per published regulatory criteria also applied for approval of the CSRC, and therefore we further classified firms as unqualified and applied firms. Further, the total number of firms that applied regardless of their eligibility was classified as applied firms. We do not have data on the number of firms that were approved. However, we know the number of firms that issued equity subsequent to the approval. We classify the firms that qualified and issued equity as qualified and issued. Some firms that applied for approval although they did not qualify under the criteria apparently obtained the approval and issued equity. To capture this sub-sample of firms, we classified firms as unqualified and issued firms. Finally, all firms that issued equity are identified as issued firms. Thus, we have a very interesting and rich data set which enables a complete analysis of the relation between capacity for equity financing and stock returns.

2 3

http://www.gtadata.com.hk/csmar. http://www.csrc.gov.cn.

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Table 2 Sample classifications and sizes. Sample category

Rights offers only

Qualified

3888 (971) 213 (207) 137 (133) 203 (197) 130 (126) 416 (404) 267 (259) 197 (197) 126 (126) 203 (197) 130 (126) 400 (394) 256 (252)

Qualified for rights offers and applied Qualified for public offers and applied Unqualified for rights offers and applied Unqualified for public offers and applied Applied for rights offers Applied for public offers Qualified for rights offers and issued Qualified for public offers and issued Unqualified for rights offers and issued Unqualified for public offers and issued Issued rights offers Issued public offers

Public offers only 2514 (911) 49 (48) 100 (98) 51 (50) 101 (100) 100 (98) 201 (198) 42 (42) 85 (85) 38 (38) 76 (76) 80 (80) 161 (161)

Both rights and public offers 2058 (261) 10 (10) 10 (10) 20 (20) 20 (20) 30 (30) 30 (30) 0 (0) 0 (0) 0 (0) 0 (0) 0 (0) 0 (0)

Neither rights nor public offers 2245 (1044) 5674 (967) 4325 (931) 4485 (1015) 5882 (1117) 10,159 (1031) 10,207 (1076) 5707 (993) 4361 (961) 4518 (1047) 5927 (1232) 10,225 (1089) 10,288 (1150)

Total

10,705 (1563) 5946 (1232) 4572 (1172) 4759 (1282) 6133 (1434) 10,705 (1563) 10,705 (1563) 5946 (1232) 4572 (1172) 4759 (1282) 6133 (1434) 10,705 (1563) 10,705 (1563)

Notes: The number of firms is in parentheses. The total number of firms is different from the sum of the any two categories in a classification such as qualified vs. unqualified. This is because the same firm could be classified as qualified in one period and unqualified in another period, and counted in both categories at different times.

3.2. Empirical models The empirical equations for estimating the relation between firm’s equity financing capacity and stock return are specified as follows: Ri,t = ai + b1 ROCapi,t−1 +

8 

cj controlij,t−1 + ei,t

(1)

cj controlij,t−1 + ei,t

(2)

j=1

Ri,t = ai + b1 POCapi,t−1 +

8  j=1

Ri,t = ai + b1 RPOCapi,t−1 +

8 

cj controlij,t−1 + ei,t

(3)

j=1

where ai represents the intercept of each model, and ei,t is an independently and normally distributed error term. The subscript i represents the firm, j stands for the specific control variable where j = 1–8, and t denotes the year. Ri,t is the annual stock return. These returns are inclusive of dividend and calculated using price and dividend data from the RESSET database.4 These models are estimated using pooled ordinary least squares regressions. ROCap is the rights offering capacity, POCap is the seasoned

4

http://www.resset.cn/en.

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public equity offering capacity, and RPOCap is the rights and seasoned public offering capacity. These three variables represent the measures of external equity financing capacity. The control variables represent a set of firm-specific fundamental variables. All the independent variables are measured as of year t − 1 relative to stock returns and described in detail below.

3.2.1. Test variables The equity financing capacity variables are determined as of the end of the previous year relative to returns on the basis of the eligibility criteria considered by the CSRC. As Table 2 shows, the overall sample and each of the sub-samples stated earlier are sub-divided into four components as rights offers only, public offers only, both rights and public offers, and neither rights nor public offers. For example, the overall sample of 10,705 observations include qualified for rights offers only (3888 observations), qualified for public offers only (2514 observations), qualified for both rights and public offers (2058 observations), and qualified for neither rights nor public offers (2245 observations). Qualified and applied sub-samples and qualified and issued sub-samples are classified in a similar manner. Then, we define equity financing capacity variables through a dichotomous dummy variable for the overall sample and for each sub-sample as follows. Qualified firms: Model (1) ROCap = 1 if qualified for rights offers only ROCap = 0 if qualified for neither rights nor public offers Model (2) POCap = 1 if qualified for public offers only POCap = 0 if qualified for neither rights nor public offers Model (3) RPOCap = 1 if qualified for both rights and public offers only RPOCap = 0 if qualified for neither rights nor public offers Qualified and applied firms: Model (4) ROCap = 1 if qualified for rights offers and applied for rights offers only ROCap = 0 if qualified for rights offers and did not apply for rights or public offers Model (5) POCap = 1 if qualified for public offers and applied for public offers only POCap = 0 if qualified for public offers and did not apply for rights or public offers Unqualified and applied firms: Model (6) ROCap = 1 if unqualified for rights offers and applied for rights offers only ROCap = 0 if unqualified for rights offers and did not apply for rights or public offers Model (7) POCap = 1 if unqualified for public offers and applied for public offers only POCap = 0 if unqualified for public offers and did not apply for rights or public offers Applied firms (qualified and unqualified): Model (8) ROCap = 1 if applied for rights offers only ROCap = 0 if did not apply for rights or public offers Model (9) POCap = 1 if applied for public offers only POCap = 0 if did not apply for rights or public offers Qualified and issued firms: Model (10) ROCap = 1 if qualified for rights offers and issued rights offers only ROCap = 0 if qualified for rights offers and did not issue rights or public offers Model (11) POCap = 1 if qualified for public offers and issued public offers only POCap = 0 if qualified for public offers and did not issue rights or public offers Unqualified and issued firms: Model (12) ROCap = 1 if unqualified for rights offers and issued rights offers only ROCap = 0 if unqualified for rights offers and did not issue rights or public offers Model (13) POCap = 1 if unqualified for public offers and issued public offers only POCap = 0 if unqualified for public offers and did not issue rights or public offers Issued firms (qualified and unqualified): Model (14) ROCap = 1 if issued rights offers only ROCap = 0 if did not issue rights or public offers Model (15) POCap = 1 if issued public offers only POCap = 0 if did not issue rights or public offers

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Table 3 Descriptive statistics on the number of firms qualified for equity issuance. Year

Rights offers

Public offers

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

293 407 440 496 524 505 623 646 678 646

624 634 66 62 70 86 406 475 497 478

In defining the benchmark against with the ROCap is defined for any particular model, we ensure that the benchmark, i.e. the observations for which dummy equals zero, does not include public issues. Similarly, when defining POCap, we exclude rights issues from the benchmark. This ensures that equity financing capacity is measured against a pure benchmark that is not contaminated by another financing event. In assessing whether a firm meets the requisite criteria, using the CSMAR database, we have manually filtered all companies for all the established requirements with only two exceptions, i.e., that the issuing firm had no harmful related-party transactions with controlling shareholders and had no public reprimands from exchanges over the previous year. Table 3 shows the number of firms that met the eligibility criteria set by CSRC for equity issuance in each year during the sample period. Quite clearly, the data show two jumps in the number of firms being eligible to apply for security issuance when the minimum three-year average ROE criteria was reduced from 10% to 6% in 2001, and from 6% to 0% in 2006. In contrast, the number of firms eligible to issue shares to the public declined drastically from 634 in 2001 to 66 in 2002 when CSRC increased the three-year average ROE threshold from 6% to 10%. With the relaxation of the ROE to 6% in 2006, the number of firms eligible for public share issues jumped to 406 from 86 in 2005. 3.2.2. Control variables Based on previous theoretical and empirical studies, we incorporate a number of variables to control for various firm-specific characteristics that could potentially affect stock returns. Firm-level control variables used in this study include firm size, firm age, ownership-type, market risk, leverage, growth, profitability, and tangibility. Firm size (SIZE) is measured by the natural logarithm of total assets. The firm’s age (AGE) is measured as the natural logarithm of the number of years from the year the firm was established. Ownership type (OWN) is measured by a dummy variable. If the largest and the control shareholder is the government, OWN takes a value of one and zero otherwise indicating private-owned firms. We use equity beta (BETA), calculated using past three years of daily returns, to control for the systematic risk. Additionally, we employ firm’s leverage (LEV), measured by the ratio of total interest bearing liabilities to equity to control for the impact of the existing level of debt on future returns.5 The market-to-book value ratio (MBV) is used as a control variable to capture firm’s growth prospects. The return on assets (ROA) is used to control for the impact of profitability on returns. Industry-type dummy variables control for any industry effects, and a time dummy variable controls for any effects of other exogenous conditions such as the macro-economic environment. Bank loans play an important role in the financing of Chinese companies. Capital structure studies also show a positive correlation between collateral, measured as the fraction of property, plant, and equipment to total assets, and bank loans (Bharath et al., 2009; Frank and Goyal, 2003; Faulkender and Petersen, 2006; Kale and Shahrur, 2007; Lemmon and Zender, 2010; MacKay and Phillips, 2005; Rajan and Zingales, 1995; Wald and Long, 2007). Tangible assets can be pledged as collateral to banks and thus allow firms to raise debt. Ni et al. (2010) point out that firms that have more tangible assets

5 Chinese firm tends to have much lower long-term debt compared to firms in other developed and emerging markets (Huang and Song, 2002).

Age (years) Total assets (RMB mil.) State ownership % Leverage Beta Market-to-book value Tangibility Return on assets Return on equity

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Mean

6.462 (3.113) 1780 (2180) 70 0.531 (0.727) 0.981 (0.232) 7.256 (5.498) 0.422 (0.166) 0.033 (0.072) 0.037 (0 .250)

6.979 (3.299) 1920 (2630) 72 0.566 (0.751) 1.052 (0.219) 5.363 (4.653) 0.428 (0.174) 0.016 (0.087) 0.008 (0.268)

7.749 (3.368) 2190 (3430) 73 0.579 (0 .721) 1.083 (0.243) 4.128 (4.139) 0.439 (0.170) 0.009 (0.091) −0.002 (0.269)

8.524 (3.430) 2510 (3960) 69 0.613 (0 .734) 1.035 (0.279) 3.198 (3.468) 0.454 (0 .171) 0.012 (0.092) 0.020 (0 .222)

9.279 (3.496) 2850 (4620) 65 0.662 (0.855) 1.069 (0. 242) 2.547 (2.857) 0.467 (0 .166) 0.009 (0.101) −0.008 (0.321)

9.936 (3.626) 2970 (5000) 62 0.645 (0 .896) 1.123 (0.232) 1.990 (2.751) 0.487 (0 .169) 0.001 (0.104) −0.026 (0.332)

10.859 (3.605) 3410 (6080) 60 0.621 (0 .887) 0.987 (0.251) 3.036 (3.980) 0.493 (0.175) 0.017 (0.090) 0.026 (0 .263)

11.555 (3.676) 4340 (7520) 59 0.578 (0 .765) 0.976 (0.260) 7.016 (6.111) 0.460 (0 .180) 0.037 (0.078) 0.071 (0 .212)

12.050 (3.930) 4910 (8590) 55 0.600 (0.802) 1.020 (0.198) 2.757 (3.421) 0.469 (0.178) 0.021 (0.090) 0.020 (0.266)

12.650 (4.171) 5660 (9580) 39 0.591 (0.848) 1.023 (0.201) 5.429 (5.051) 0.452 (0 .182) 0.027 (0.086) 0.047 (0.235)

9.908 (4.147) 3420 (6320) 62 0.601 (0.808) 1.035 (0.236) 4.184 (4.651) 0.459 (0 .175) 0.018 (0.091) 0.020 (0.267)

Note: Standard deviations are in parenthesis.

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Table 4 Descriptive statistics on key firm characteristics.

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Age (years) Total assets (RMB mil.) Leverage Beta Market-to-book value Tangibility Return on assets Return on equity Stock return (year t − 1)

Qualified vs. unqualified firms

Qualified firms only

Rights offers

Rights offers

Public offers

Rights offers

Public offers

Public offers

Qualified

Unqualified

Qualified

Unqualified

Applied

Not applied

Applied

Not applied

Issued

Not issued

Issued

Not issued

9.35 6210 0.50 1.02 4.43 0.47 0.06 0.11 0.45

10.29 3200 0.67 1.04 3.84 0.45 −0.01 −0.04 0.38

8.78 6780 0.43 1.01 4.03 0.45 0.06 0.11 0.58

10.31 3600 0.66 1.04 4.60 0.46 0.00 −0.01 0.34

10.97 8540 0.53 1.05 4.41 0.48 0.05 0.11 1.32

9.28 6120 0.50 1.02 3.82 0.47 0.06 0.11 0.41

10.07 9090 0.47 1.01 3.50 0.46 0.06 0.11 0.43

8.73 6680 0.43 1.01 4.54 0.45 0.06 0.11 0.58

10.87 8640 0.53 1.05 4.44 0.48 0.05 0.10 1.35

9.29 6120 0.50 1.02 3.82 0.47 0.06 0.11 0.41

9.27 9360 0.39 0.98 3.28 0.42 0.06 0.10 0.28

8.76 6710 0.43 1.01 4.48 0.45 0.06 0.11 0.59

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Table 5 Key characteristics of qualified and unqualified firms.

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are more likely to access loans from banks as they have more mortgageable property. The tangibility ratio (TAN) is used to capture the firm’s ability to finance through bank loans, and we compute it as the property, plant and equipment and inventories divided by total assets. Table 4 shows the mean and the standard deviation of key firm-specific characteristics on an annual basis over the sample period. The average age of the firm is about 10 years, and as one would expect, the age has increased over the sample period. The firm size, measured in terms of total assets, has averaged about 3.4 billion RMB and has increased every year to about 5.6 billion RMB by 2009. The financial leverage, which shows the debt/equity ratio, has also risen from 53% in 2000 to 59% in 2009, and the average is about 60%. This suggests that on average the debt as a percent of total assets is about 38%. The market-to-book ratio has varied quite a bit suggesting volatility in growth prospects. The tangibility, which shows the tangible assets as a proportion of total assets, has averaged about 46% and shown a slight increase over time. Thus, the ability of firms to use tangible assets as collateral to obtain bank financing has been fairly stable during the sample period. The profitability has also varied with an average of about 2% implying that on average Chinese companies have not been very profitable. Table 5 shows key characteristics of qualified and unqualified firms for rights and public share issues. These data show that firms that became eligible to issue equity, both rights and public offers, are larger, less-leveraged and more profitable firms than firms that were not eligible. The firms that qualified to apply for rights issues also show higher growth prospects than unqualified firms while those firms that qualified to apply for public issues show less growth prospects than unqualified firms. Further, firms that were eligible for equity issuance have had higher stock returns in the previous year compared with firms that did not qualify. 4. Empirical results Table 6 presents the correlation coefficients of the variables included in the regressions. The correlations are generally very low and do not raise any multicollinearity concerns. Variance Influence Table 6 Correlation matrix. Panel A: Correlation between control variables

Ln (AGE) Ln (SIZE) OWN LEV BETA MBV ROA TAN

Returns

Ln (AGE)

Ln (SIZE)

OWN

LEV

BETA

MBV

ROA

0.1892* 0.0590* −0.1079* −0.0123 −0.1317* 0.3141* 0.1371* 0.0025

0.0173 −0.2129* 0.0832* −0.0733* 0.0574* −0.0948* 0.0260*

0.1734* 0.1592* 0.0917* −0.2113* 0.2386* 0.1921*

0.0010 0.0696* −0.0796* 0.0613* 0.1070*

0.0406* 0.4339* −0.1078* 0.1015*

−0.1935* −0.0369* −0.0192

−0.0130 −0.0784*

0.0266*

Panel B: Correlation between equity financing capacity variables and returns Equity financing capacity variable

Returns

ROCap – qualified firms POCap – qualified firms ROCap – qualified and applied firms POCap – qualified and applied firms ROCap – unqualified and applied firms POCap – unqualified and applied firms ROCap – applied firms POCap – applied firms ROCap – qualified and issued firms POCap – qualified and issued firms ROCap – unqualified and issued firms POCap – unqualified and issued firms ROCap – issued firms POCap – issued firms

−0.0692* −0.0129 −0.1831* −0.0328 −0.1371* 0.0161 −0.1551* −0.0330* −0.1818* −0.0483* −0.1379* −0.0087 −0.1436* −0.0130

*

Significant at 5%.

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Table 7 Regression of stock returns with equity financing capacity for qualified firms. Model

(1) Rights offers

(2) Public offers

(3) Both

Constant

−1.097*** (0.164) −0.008 (0.013) 0.031*** (0.007) −0.001 (0.0130) −0.048*** (0.009) −0.063** (0.025) 0.026*** (0.002) 0.145* (0.080) 0.088** (0.035) −0.057*** (0.012)

−0.391** (0.199) −0.018 (0.015) 0.016* (0.008) 0.000 (0.015) −0.043*** (0.010) −0.060** (0.030) 0.022*** (0.002) 0.166** (0.084) 0.095** (0.041)

−0.767*** (0.172) −0.015 (0.015) 0.017** (0.008) −0.005 (0.015) −0.042*** (0.010) −0.030 (0.029) 0.028*** (0.002) 0.120 (0.085) 0.137*** (0.039)

AGE SIZE OWN LEV BETA MBV ROA TAN ROCap

−0.053*** (0.016)

POCap RPOCap N Adj. R2

6133 0.74

4759 0.75

−0.002 (0.019) 4303 0.72

Notes: Robust standard errors are in parentheses. * Significance at 10%. ** Significance at 5%. *** Significance at 1%.

Factor also confirmed that there is no severe problem of multicollinearity. To ensure that the results are not driven by outliers, we winsorized all dependent and independent variables at 1% level (1 and 99 percentiles). White’s test for heteroscedasticity indicated a heteroscedasticity problem. In order to correct for heteroscedasticity, we use robust regressions. 4.1. Qualified firms The regression results for qualified firms are provided in Table 7. We also control for any industry effects and macroeconomic conditions through industry and year dummies in all models, but do not report the coefficients associated with industry and year dummy variables. The regression results show that firm AGE and OWN are not significantly related with future stock returns. SIZE, MBV, ROA and TAN are significantly positively related with returns suggesting that the larger firm size, higher growth, higher profitability and larger tangibility are associated with higher future returns. The reliably positive tangibility confirms the value of capacity for bank financing, which Chinese firms heavily depend on due to the limited accessibility to public debt and equity markets. LEV and BETA are significantly negatively related indicating that higher leverage and higher systematic risk are associated with lower future returns. Our main variables of interest are the capacity for right offers and the capacity for public offers. The estimates of model (1) show that for the firms that qualified for rights offers only, ROCap is significantly negatively related with future returns at 1% level. Similarly, model (2) shows that for the companies that qualified for public offers only, POCap is also significantly negatively related with future returns at 1% level. However, for the firms that qualified for both rights and public offers, RPOCap shows no

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Table 8 Regression of stock returns with equity financing capacity for applied firms. Qualified firms

Unqualified firms

All firms

Model

(4) Rights offers

(5) Public offers

(6) Rights offers

(7) Public offers

(8) Rights offers

(9) Public offers

Constant

−1.374*** (0.198) −0.012 (0.015) 0.026*** (0.008) 0.029* (0.016) −0.013 (0.017) 0.129*** (0.034) 0.066*** (0.006) 0.461** (0.212) 0.075 (0.045) −0.327*** (0.065)

−0.823*** (0.240) 0.004 (0.017) 0.013** (0.011) 0.021 (0.022) 0.032 (0.027) 0.143*** (0.047) 0.071*** (0.006) 0.938*** (0.272) 0.034 (0.060)

−0.707*** (0.198) −0.017 (0.016) 0.014* (0.008) 0.007 (0.016) −0.041*** (0.010) −0.070** (0.031) 0.021*** (0.002) 0.182** (0.083) 0.127*** (0.042) −0.119* (0.066)

−1.175*** (0.167) −0.007 (0.013) 0.035*** (0.007) 0.004 (0.013) −0.046*** (0.009) −0.072*** (0.026) 0.024*** (0.002) 0.208*** (0.078) 0.120*** (0.036)

−1.071*** (0.148) −0.0085 (0.011) 0.028*** (0.006) −0.002 (0.012) −0.049*** (0.009) −0.037 (0.024) 0.030*** (0.002) 0.116* (0.078) 0.117*** (0.033) −0.194*** (0.046)

−1.093*** (0.153) −0.0092 (0.011) 0.031*** (0.006) −0.004 (0.012) −0.048*** (0.009) −0.018 (0.024) 0.029*** (0.002) 0.110 (0.076) 0.114*** (0.032)

AGE SIZE OWN LEV BETA MBV ROA TAN ROCap POCap N Adj. R2

5887 0.70

−0.004 (0.060) 4425 0.68

4688 0.75

−0.105* (0.057) 5983 0.74

10,575 0.72

−0.030 (0.039) 10,408 0.73

Notes: Robust standard errors are in parentheses. * Significance at 10%. ** Significance at 5%. *** Significance at 1%.

reliable relation with returns. These results suggest that firms having the capacity to make rights and public offers experience negative returns in the subsequent year. 4.2. Applied firms Next, we investigate qualified, unqualified, and all firms that in fact applied for approval from the CSRC to issue equity. ROCap takes the value of one for firms applied for approval to make a rights issue only and zero otherwise. Similarly, POCap takes the value of one for firms applied for approval to make a public share issue only and zero otherwise. If the market views the capacity for external equity issues negatively, as confirmed by the previous results relating to qualified firms, then such effects should be even more stronger when a qualified firm in facts makes it known of its intention to proceed with equity issues by applying for regulatory approval. The results reported in Table 8 in fact show that ROCap is strongly negatively related with returns (model 4). The coefficient for ROCap is −0.327, which is much larger than the value of −0.057 observed in respect of the qualified firms in model 1. However, POCap becomes insignificant for qualified and applied firms. Thus, there is very strong evidence that the market views the capacity to issue rights negatively and more so for firms exhibiting their intention to make rights offers, which is by far the most dominant form of new equity capital in China. We also look at the subset of firms that do not qualify and yet decide to apply for approval to issue equity.6 The results show that ROCap is negative and significant only at 10% (model 6). This

6 Some of these firms include state-owned enterprises and firms in some priority sectors that are given preferential treatment by the CSRC.

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Table 9 Regression of stock returns with equity financing capacity for issued firms. Qualified firms

Unqualified firms

All firms

Model

(10) Rights offers

(11) Public offers

(12) Rights offers

(13) Public offers

(14) Rights offers

(15) Public offers

Constant

−1.394*** (0.199) −0.012 (0.015) 0.026*** (0.008) 0.031* (0.016) −0.010 (0.017) 0.132*** (0.034) 0.066*** (0.005) 0.459** (0.212) 0.071 (0.045) −0.341*** (0.067)

−0.540** (0.246) 0.003 (0.017) 0.012** (0.010) 0.019 (0.022) 0.034 (0.027) 0.140*** (0.048) 0.070*** (0.005) 0.948*** (0.275) 0.029 (0.060)

−0.721*** (0.199) −0.017 (0.016) 0.015* (0.008) 0.006 (0.016) −0.040*** (0.010) −0.065** (0.031) 0.021*** (0.002) 0.185** (0.084) 0.127*** (0.042) −0.108* (0.067)

−1.463*** (0.169) −0.007 (0.013) 0.036*** (0.007) 0.004 (0.013) −0.045*** (0.009) −0.069*** (0.026) 0.023*** (0.002) 0.210*** (0.078) 0.121*** (0.036)

−0.946*** (0.150) −0.010 (0.011) 0.028*** (0.006) −0.003 (0.012) −0.049*** (0.009) −0.033 (0.024) 0.030*** (0.002) 0.116* (0.078) 0.121*** (0.033) −0.191*** (0.046)

−1.126*** (0.145) −0.009 (0.011) 0.031*** (0.006) −0.005 (0.012) −0.047*** (0.009) −0.017 (0.024) 0.029*** (0.002) 0.111* (0.076) 0.115*** (0.032)

AGE SIZE OWN LEV BETA MBV ROA TAN ROCap POCap N Adj. R2

5904 0.70

−0.017 (0.050) 4446 0.68

4721 0.75

−0.104* (0.060) 6003 0.74

10,625 0.72

−0.003 (0.037) 10,449 0.73

Notes: Robust standard errors are in parentheses. * Significance at 10%. ** Significance at 5%. *** Significance at 1%.

less-stronger relation with returns may indicate that market recognizes the lower probability of approval for unqualified firms. POCap is also negatively related with returns for unqualified and applied sample (Model 7) although only at 10% level of significance. For all firms that applied, including both qualified and not qualified, the results indicate a strongly negative ROCap (model 8) and insignificant POCap (model 9). The evidence so far clearly suggests that the market views rights offers negatively for firms that apply to make rights offers, and this effect is stronger when firms in fact have the capacity to make rights offers, i.e., for qualified firms. 4.3. Issued firms Our final level of analysis involves firms that issued shares through either rights or public offers. Although we continue to name them as ROCap and POCap for convenience, they in fact represent firms that issued equity. These firms will provide the clearest evidence on the relation between equity financing and stock returns. Table 9 shows the results relating to qualified, unqualified and all firms that went on to issue shares after obtaining regulatory approval. ROCap is strongly negatively related with future returns at 1% level (model 10), and the level of the coefficient is larger than that observed in respect of qualified and applied firms. POCap continues to be insignificant. For the subset of unqualified firms that ultimately issued equity, while both ROCap and POCap are negative, they are only significant at 10%. Finally, we examine firms that issued equity whether they qualified or unqualified. The results show that ROCap is strongly negative while POCap is insignificant. Overall, the results suggest that the market views rights issues negatively, particularly when such firms in fact have the capacity to issue them as determined by the regulatory qualification criteria.

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5. Summary and conclusions This study examines the relation between the equity financing capacity and stock returns using a comprehensive sample of listed firms in China for the time period from 2000 to 2009. The eligibility to issue securities is governed by CSRC regulations. The regulations essentially create a setting in which some firms become eligible to raise funds externally while others do not have that capacity. We examine the relation between capacity for rights issues and capacity of seasoned public equity issues, and subsequent stock returns after controlling for a battery of control variables that are known to impact stock returns. The main results show that the capacity for rights and public offers of shares is strongly negatively related with future returns for firms that met the regulatory criteria. For firms that met the regulatory criteria and applied, and for firms that issued equity after meeting regulatory criteria and obtaining approval, the capacity to make rights offers is strongly negatively related with future returns. These results are consistent with agency, signaling as well as earningsmanagement hypotheses, which predict a negative relation between equity issuance and subsequent returns. Further research is necessary to differentiate among alternative explanations for the observed relations. References Bharath, S., Pasquariello, P., Wu, G., 2009. Does asymmetric information drive capital structure decision. Review of Financial Studies 22, 3211–3243. Cohen, D.A., Lys, T.Z., 2006. Weighing the evidence on the relation between external corporate financing activities, accruals and stock returns. Journal of Accounting and Economics 42, 87–105. Dechow, P.M., Richardson, S.T., Sloan, R.G., 2008. The persistence and pricing of the cash component of earnings. Journal of Accounting Research 46, 537–566. Frank, M., Goyal, V., 2003. Checking the pecking order theory of capital structure. Journal of Financial Economics 67, 217–248. Faulkender, M., Petersen, M.A., 2006. Does source of capital affect capital structure? Review of Financial Studies 19, 45–79. Huang, S., Song, F., 2002. The determinants of capital structure: evidence from China. Working Paper. University of Hong Kong. Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323–339. Jensen, M.C., Meckling, W.H., 1976. Theory of the firms: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3, 305–360. Kale, J., Shahrur, H., 2007. Corporate capital structure and characteristics of suppliers and customers. Journal of Finance 53, 321–365. Lemmon, M.L., Zender, J.F., 2010. Debt capacity and test of capital structure theory. Journal of Finance and Quantitative Analysis 45, 1161–1187. Loughran, T., Ritter, J.R., 1995. The new issues puzzle. Journal of Finance 50, 23–51. Loughran, T., Ritter, J.R., 1997. The operating performance of firms conducting seasoned equity offerings. Journal of Finance 52, 1823–1850. Loughran, T., Ritter, J.R., 2000. Uniformity least powerful tests of market efficiency. Journal of Financial Economics 55, 361–389. MacKay, P., Phillips, G., 2005. How industry affect firm financial structure. Review of Financial Studies 18, 1433–1466. Myers, S., Majluf, N., 1984. Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics 13, 187–221. Ni, Y., Guo, S., Giles, D.E.A., 2010. Capital structures in an emerging market: a duration analysis of the time interval between IPO and SEO in China. Applied Financial Economics 20, 1531–1545. Papanastasopoulos, G., Dimitrios, T., Wang, T., 2008. Accruals and the performance of stock return following external financing activities. Working Paper. Rajan, R., Zingales, L., 1995. What do you know about capital structure: evidence from international data. Journal of Finance 50, 1421–1460. Ritter, J.R., 2003. Investment banking and securities issuance. In: Constantinides, G.M., Harris, M., Stulz, R.M. (Eds.), Handbook of Economics and Finance: Corporate Finance, vol. 1A. Elsevier Science B.V. Spiess, D.K., Affleck-Graves, J., 1995. Underperformance in long-run performance of stock returns following seasoned equity offerings. Journal of Financial Economics 38, 243–267. Wald, J.K., Long, M.S., 2007. The effect of state laws on capital structure. Journal of Financial Economics 83, 297–320.