Impact of bankruptcy risk on the interactive relationship between debt financing and corporate investment decisions: evidence from China.

Author:Xing, Liu

    The interactive relationship between corporate debt financing and investment is an important issue in modern corporate financial management. In 1958, Modigliani and Miller (MM) investigated the relationship between these two variables under the conditions of perfect capital markets, and derived the classic MM theory. They asserted, under conditions of perfect capital markets, corporate investment decisions primarily depend on basic economic variables such as profitability and cash flows, and are unrelated to the manner in which debt is financed. However, overwhelming empirical evidence shows that capital markets are not perfect. As a result, the independence of these variables from each other under the MM propositions may be questionable. Researchers have also examined the propositions in the presence of taxes, bankruptcy costs, and agency costs with no clear consensus.

    Prior research regarding the interactive relationship between investment and debt decisions can be categorized into three groups. First, Dhrymes and Kurz (1967) began by defining the major problems of the firm as raising funds and profits, new debts, and equity and spending them on investment and dividends. They set up a three-equation simultaneous equation model using dividends, investment, and new debts as independent variables. Each equation contained the remaining two independent variables as two of its explanatory and endogenous variables. They argued that, because of the cash flow constraint, sources of funds would affect uses of funds positively and other sources negatively. If the firm expended large amounts of funds on investment, other things being equal, it would then tend to pay less in dividends and/or obtain more external financing. Second, the reason why debt financing decision could affect investment decision is because debts can (1) create tax savings through interest deduction, and (2) increase bankruptcy costs. As a result, it would affect corporate investment decisions. On the other hand, investment would result in profits and depreciation, thus affecting profits after tax and bankruptcy cost if debt financing is used. Third, agency theorists believe that debt financing may lead to either over-investment or under-investment. These two types of behavior would result in decline in a firm's value. Thus, debt financing is often viewed as a negative behavior.

    This paper attempts to study the interactive relationship between debt financing and investment decision of Chinese listed companies from the perspective of bankruptcy risk, in order to assist Chinese listed companies to make better financing and investment decision as well as to provide empirical evidence of how economic resources can be allocated more efficiently.


    Much research on bankruptcy risk emerges to explain the theory of capital structure. In response to the MM proposition as modified by income tax, Baxter (1976) introduced financial leverage in the study of bankruptcy risk, and explained the reason why firms did not choose to use debt exclusively when raising capital. He believed under the condition of bankruptcy risk, firms cannot continuously increase their financial leverage. As debt ratio increases, a firm's bankruptcy risk will rise, thus increasing its expected bankruptcy cost and offsetting the benefit of tax savings of debt interest. Under this scenario, a firm's cost of capital does not always decrease when debt rises, but will increase at higher debt level. Therefore, the optimal debt ratio is between 0 and 1. Kraus and Litzenberger (1973) studied the optimal financial leverage level and pointed out that the value of a firm with debt equals to the value of a firm without debt plus the product of the market value of debt and the income tax rate, and minus the after-tax value of its expected bankruptcy cost. They stressed the importance of the negative impact of bankruptcy cost towards a firm's value. Stiglitz (1972) believed that the probability of bankruptcy significantly affects a firm's investment behavior, such as merger and acquisition. If a firm considers the potential bankruptcy risk and its resultant high bankruptcy cost, they may abandon their merger and acquisition plans. Under this view, Jensen (1986) concluded that under the bankruptcy mechanism, debt financing would usually create a corporate governance effect on a firm's investment decisions. This is due to the fact that debt financing would increase bankruptcy risk, thereby increasing the risk of a manager's loss of control power. In order to reduce bankruptcy risk, a manager may reduce his/her business expenses, work harder, and invest more carefully. Therefore, increase in debt financing may lead to less investment activities. Myers (1977) examined the negative impact of bankruptcy risk from the perspective of investment deficiency. He believed that, under high debt level, a firm may not invest in projects with expected positive net cash flows. He explained that if a firm goes bankrupt, creditors may be able to recover their losses but stockholders would have to bear the consequences of bad investment decisions. Martin and Scott (1976), Hong and Rappaport (1979), and Rhee and McCarthy (1982) explored how debt capacity and capital investment decisions affect bankruptcy risk. They believed that bankruptcy cost is determined by the probability of bankruptcy times total debts. Bankruptcy is the inability of a firm's cash flows in meeting its debt and interest obligations. As a result, the probability of bankruptcy of a firm not only depends on the amount of debt financing, but also the distribution of its cash flows. Accordingly, a firm can use investment to manage its cash flows and fluctuation, which will affect bankruptcy risk and the optimal debt level. Therefore, Martin and Scott (1976) pointed out that those firms which can control their investments' cash flow fluctuation will be able to expand their debt capacity and increase their optimal debt level. Jensen and Meckling (1976) concluded that in diversified shareholding in most business, ownership and management are separated. Potential conflict of interest exists between shareholders and managers. Because of self interest such as power and compensation, a manager may sacrifice the interest of shareholders and pursue the growth of a firm, causing excessive investment (Jensen, 1986 and Stulz, 1990). At this time, the firm's investment may increase bankruptcy risk and discourage the increase of debt level. They also believed, when a firm's share ownership is more concentrated, shareholders could have more control of the firm. Managers and shareholders' goals are similar, and the firm will have a strong incentive to invest in high-risk projects. This is because if the projects are successful, shareholders would reap most of the profits. If the projects are unsuccessful, then the losses are mostly born by the creditors. Since the tolerance for high risk will reduce the risk threshold for investment projects and expand the investment opportunity set, this asset substitution phenomenon is a symbol of excessive investment incentive (Mauer and Sarkar, 2005). Finally, a firm's investment not only would not improve the risk condition, on the other hand, it would increase the volatility of income, raise the bankruptcy risk, and negatively impact a firm's future debt level.

    In summary, investment and financing decisions would affect a firm's bankruptcy risk, and bankruptcy risk will also affect investment and financing decisions. Therefore, because of bankruptcy risk, a firm's investment and financing decisions become an interactive relationship. We develop the following hypotheses:

    Hypothesis 1a: Debt financing would increase a firm's bankruptcy risk, and bankruptcy risk would reduce a firm's investment level.

    Hypothesis 1b: Through bankruptcy risk, debt financing would create corporate governance effect to non-control, low-growth firms; and cause under-investment of absolute-control and high-growth firms.

    Hypothesis 2a: Investment would decrease a firm's bankruptcy risk, and bankruptcy risk would reduce a firm's debt financing level.

    Hypothesis 2b: Non-control (absolute-control) and low-growth firms would over-invest (asset substitution) and increase the firms' bankruptcy risk, and discourage the increase of debt financing.


    3.1. Sample Selection and Data Source

    This study uses 730 companies that were traded in the Shanghai and Shenzhen Stock Exchanges during the 2001-2005 period. The 730 companies yield 3,650 observations. Criteria for sample selection were: (1) Banks and other financial institutions were excluded because their financial conditions are significantly different from non-financial companies, (2) Firms that issued B and H shares were excluded, (3) Companies with incomplete data were excluded. Our financial data were obtained form CCER data base, while our market data and corporate governance data were obtained from CSMAR data base.

    3.2. Model Development and Research Methodology

    The primary research objective of this study is to analyze the interactive relationship between investment and debt financing decisions from the perspective of bankruptcy risk. In other words, we analyze a firm's investment and debt financing behavior from the perspective of bankruptcy risk and project its impact on future investment and debt financing decisions. Therefore, we developed the following system of simultaneous equations:

    [R.sub.t-1] = [[alpha].sub.1] + [[lambda].sub.1t] + [[beta].sub.1][I.sub.t-1] +...

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