Does the Pecking Order Theory Apply to Chinese Publicly Traded Companies? Evidence from Manufacturing Sector

The pecking order theory is one of the most crucial theories in corporate finance field. Empirical test on this theory is very common in western coun-tries while domestic empirical study is still relatively limited in China. The majority of previous studies mainly concentrate in the whole capital market. Over the last decade, manufacturing sector experienced incrementally rapid development in China. The manufacturing sector not only makes critical contributions to China’s economy and society development, but also becomes key force in supporting the world economy. Thus, this article tests pecking order theory on Chinese publicly traded firms in manufacturing sector. Using a panel of 1212 observations during the period between 2013 and 2015, we draw the conclusion that there is no evidence to back up the pecking order theory. Further subsample analysis indicates that pecking order does not apply to Chinese manufacturing listed firms with both high float shares ratio and low float shares ratio.

Western scholars have been studying enterprises' financing preference for a long time. The pecking order hypothesis proposed by Myers and Majluf [1] brings research of the modern corporate finance to a new height. Generally speaking, western scholars believe that the pecking order theory has high explanatory power for firms' financing behavior. Under normal circumstances, when companies face funding gap, they prefers internal funds, followed by debt financing, and finally equity financing. Internal financing and debt financing often accounted for most of the company's financing.
But in China, the application of pecking order theory has been challenged. Two events, "Split-share structure reform" and "the rise of the corporate bond market", are not the object of our article. This article concerns that, after the split-share reform, whether financing preference of China's listed companies varies or not?
In the past decade, manufacturing sector experienced incrementally rapid development in China. Both the overall scale and the comprehensive strength have been significantly increasing. Thus, it is of interest to study the financing behavior in Chinese manufacturing sector. Does pecking order theory apply to Chinese manufacturing listed firms?
Our study examines the financing preference of 404 Chinese listed firms with financing deficit in manufacturing industry. And then we test pecking order theory on subsamples classified by the percentage of floatable shares.

Literature Review
Myers and Majluf [1] propose the pecking order theory considering information asymmetry between management inside and potential investors outside to analyze the firm's financing choices. Managers on behalf of old shareholders know clearly about the current condition and the prospect of the firm while outside risk for firm because it is least affected by the costs of information and has less adverse selection problem. By contrast, both debt and equity are subject to adverse selection problems. For a potential investor, equity has much more risk than debt has. This is because equity has larger adverse selection risk premium.
Therefore, investors outside will obviously pursue a higher rate of return on equity than on debt. Thus, for firms, they will fund all projects with internal funds

Methodology
According to Shyam-Sunder and Myers [3], the pecking order theory is to test: and Goyal [4] indicate that the current portion of long-term debt should be excluded from financing deficit. And we follow the definition for financing deficit in Frank and Goyal's [4] approach.
In the case of ideal conditions, changes in corporate debt issues should usually track the financing deficit perfectly, thus, the pecking order estimate β should equals 1 and constant α approaches 0, statistically significantly. Shyam-Sunder and Myers [3] do not include debt capacity constraints faced by companies in their empirical model, but they believe that the presence of borrowing constraints would only slightly reduce the coefficient β , which does not affect the empirical results, and the borrowing constraints faced by mature and large companies are not serious. The pecking order theory argues that financing behavior is affected by adverse selection costs to a large extent. Therefore, this theory should best apply to companies facing particularly serious adverse selection problems. Small-sized companies at growth stage are often regarded as companies with large information asymmetries.
Shyam-Sunder and Myers [3] model has been criticized by some scholars, and it is considered that the explanatory power is not strong. Then I follow Lemmon and Zender [5] approach, adopting their modified model to do the more precise test. The empirical specification behind this model is: In this regression, if pecking order theory holds, the estimate of the pecking order parameter (β) and R 2 of the regression should see an obvious increase. Besides, estimating Equation (2)  1) Reserve observations with negative DEF value. We refer to this as sample 1.
3) Exclude observations with negative DEF value. Since our goal is to examine how the firms with financing needs choose funds, it's better for enhancing the accuracy of the empirical results by excluding observations which have DEF less than 0. This is referred to as sample 3.   And the amount of cash flow (C t ) driven from operating activities reaches 8.00E+08 on average, illustrating that the firms in our sample have strong profitability and thus have sufficient internal funds to cover the funding gap. Table 3 lists the summary of correlation among all variables in Equation (1) and Equation (2). It can be found that deficit and net debt is positively correlated and the correlation coefficient is 0.26 approximately, which indicates that the portion of extra capital needs financed by debt issues is low. Net working capital has the highest positive correlation with financing deficit, suggesting that extra needs for net working capital is most possible to lead to financing deficit. Both the operating cash flow and dividend are negatively correlated with financing deficit. The absolute value of these correlation coefficients is almost lower than 0.5. Therefore, there is no serious multicollinearity in our two regressions.

Empirical Results
In terms of panel data, the pooled OLS is used when the explanatory variable is independent of the error term. The redundant fixed effects test illustrates that there is no individual effect in our sample so that pooled OLS model is adopted here. Table 4 shows that, in sample 1 (with observations having negative financing deficit), the pecking order coefficient is 0.11 (in column (1)

Disaggregating the Data
In order to test the pecking order theory on our manufacturing listed companies more particularly, we break down the data into three subgroups according to the free float methodology. Due to the fact that firms in our sample have relatively high free float ratio, we break down the overall sample into group 1 (float of shares no larger than 60%), group 2 (float of shares between 60% -80%), and group 3 (float of shares between 80% -100%). We do both the redundant fixed effects test and Hausman test to choose the most appropriate regression model.
And as mentioned above, panel EGLS is used in our regression. In terms of processing data, we follow the previous methods to treat the observations with negative financing deficit.

Empirical Results on Group 1 (Firms with Floatable Shares below 60%)
Analyzing our data, a panel of 99 companies that have float of shares below 60% are obtained. We do not exclude observations that have negative financing deficit when Estimating Equation (1) and Equation (2)  As seen in Table 6, the pecking order coefficient in column (1)  needs. However, R 2 of both samples is very low, which might is resulted from the small sample sizes. So we need to estimate Equation (2) to see more precise results and then make the conclusion.
Then we follow the Lemmon and Zender (2010) (2) for sample 1 and sample 2 respectively. The results contain an intercept figure, but not listed. P-values are presented in brackets. N is the number of observation. shares. In this case, refinancing will lead non-tradable shares to obtain equity appreciation undoubtedly. Therefore, the board controlled by non-tradable shareholders will not easily decide to give up equity financing when the firm needs extra financing. The absolute control by major shareholders causes the minority of shareholders unable to contend with the resolution of the board.
These facts might give an explanation to our empirical results on group 1.

Empirical Results on Group 2 (Firms with Floatable Shares between 60% -80%)
Findings for firms that have 60% -80% tradable shares show that pecking order theory does not hold in past three years. Redundant fixed effects test and Hausman test demonstrate that fixed effects model should be used here. It can be seen that the estimate of β coefficient is −0.15 (Column (1) in Table 8), suggesting that when internal funds are exhausted firms choose to issue equity to finance capital gap and pay back about 15% debt that they issued in the past. Substituting DEF with adjusted DEF (making ADEF = Max (DEF, 0)), we find that the figure for β parameter is −0.17, significantly at 1% significance level. Both samples have a moderately high R 2 . Obviously, these results show that manufacturing firms with 60% -80% outstanding stocks prefer equity financing instead of debt financing when there is funding deficit. Therefore, in this case, pecking order theory is not applicable to firms in group 2.
And the results obtained from estimating Equation (2) is consistent with it.
The significantly negative slope coefficients in column (1) and (2) of Table 9 indicate that these firms choose equity issuing once internal funds are not enough to fund deficit. Although the estimates of squared financing deficit are both negative, they are not significant. Both samples have a moderately high R 2 . These firms have floatable shares between 60% -80%, yet there is close interest nepotism between the big shareholders and controlling shareholders in most Chinese listed companies, including the manufacturing sector. These minority big shareholders might be the co-founder of the company when it was founded or equity investors introduced by controlling shareholders in order to meet listing requirements. Apart from this, big shareholders might be the family group of controlling shareholders. The presence of these minority big shareholders cannot effectively supervise the controlling shareholders, but will intensify the control by the controlling shareholders.

Empirical Results on Group 3 (Firms with Floatable Shares between 80% -100%)
Results for firms with floatable shares between 80% -100% indicate that pecking order theory is not applicable for these firms. Based on redundant fixed effects    (2) for sample 1 and sample 2 respectively. The results contain an intercept figure, but not listed. P-values are presented in brackets. N is the number of observation. test, pooled OLS model is appropriate when estimating both Equation (1) and Equation (2). According to the column (1) of Table 10 and   Table 10 shows that deficit is financed by around 35% of debt issues and the goodness of fit approaches 72% approximately. But the results driven from estimating Equation (2) show no evidence of supporting the pecking order hypothesis. As seen in Table 11, we find that estimate for β coefficient declines by about 7%. And estimate for squared deficit is significantly positive, indicating that firms do not rely on equity financing when the deficit is large and exceeds debt capacity constraints. However, the explanatory power of this regression increases to 84%.

Conclusions
Modern corporate finance theory originated from MM theorem [8] in the late Our article aims to examine the pecking order hypothesis on Chinese publicly traded companies in manufacturing sector during the period from 2013 to 2015.
By using Shyam-Sunder and Myers [3] model and Lemmon and Zender [5] model, we find that pecking order theory does not hold in our sample. Further, we break down our sample based on the percentage of floatable shares of each firm.
The results driven form each subsample show that neither firms with low float shares ratio nor firms with high float shares ratio issue debt primarily to cover financing deficit when internal funds are exhausted. It should be noticed that our article does not study whether these firms use internal sources to cover funding gap since the model we use is based on that firms use internal funds first.