How does capital structure affect competition among technological firms in Asia

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ФЕДЕРАЛЬНОЕ ГОСУДАРСТВЕННОЕ АВТОНОМНОЕ ОБРАЗОВАТЕЛЬНОЕ УЧРЕЖДЕНИЕ

ВЫСШЕГО ПРОФЕССИОНАЛЬНОГО ОБРАЗОВАНИЯ

«НАЦИОНАЛЬНЫЙ ИССЛЕДОВАТЕЛЬСКИЙ УНИВЕРСИТЕТ

«ВЫСШАЯ ШКОЛА ЭКОНОМИКИ»

Международный институт экономики и финансов

Влияет ли структура капитала на конкуренцию на рынке технологических продуктов в Азии

(How does capital structure affect competition among technological firms in Asia)

Выпускная квалификационная работа - БАКАЛАВРСКАЯ РАБОТА

по направлению подготовки 38.03.01 «Экономика»

образовательная программа «Программа двух дипломов по экономике НИУ ВШЭ и Лондонского университета»

Габлина Вера Андреевна



Introduction

The theme of the dependence between financial leverage and competition interested scholar since late 80s. This paper analyses the relationship between capital structure (measured as debt ratio) and market competition (measured as HHI index). I have studied an unbalanced dataset for years from 1998 to 2017 on 314 companies in China by using a pooled OLS and fixed effect regression models. I have found positive and significant relationship between debt ratio and HHI index, and the type of this relationship is non-linear. My research is new in this area of analysis as I have used the most recent information, and as far as technological industry develops with high pace in China, this is an important theme to analyse.



Chapter 1. Theoretical part

1.1 Development of the theory

As nowadays most financial economists agree that capital structure affects firms' actions concerned product market actions, the amount of output to produce, etc, before 80s most of the works were divided into those, concerned industrial organization field, and those concerned corporate finance. The first researchers created models which tried to explain the connection (and interrelation) of corporate structure and market actions of firms. Nevertheless, empirical results were not presented. One of the pioneers to investigate this question was Phillips (1993). In his work he stated that firms' capital structure affects its own and competitors output/pricing decisions among four industries in the U.S. He concluded that, among three of four firms, increased financial leverage results in the decrease of output and expenditures, whether in gypsum industry the positive change in debt/equity ratio leads to increase in output, which results in decrease in price. These differences are due to difficulties associated with entrance, as well as rivals' leverage. One of the main conclusions of his work, the higher the indebtedness of the firm, the lesser the aggressiveness of the behavior of the firm.

Another empirical research was conducted by Campello (2002), who doubted the straight impact of changes in firm's leverage on the market structure of the industry as there may be unobserved factors that may influence the market environment, so he analyzed the output growth and markup dynamics with respect to business cycles and shocks of aggregate demand.

debt negatively influences sales growth of poorly levered firms during decrease in aggregate demand (recession), though during the positive change in the business cycle there is no particular relationship. Also, when industry leverage is sufficient, markups increase more during fall in aggregate demand and vice versa. The main result is that highly levered firms are eager to increase short-term profits by losing the ability to increase sales during recessions. It is consistent with the prediction of Chevalier and Scharfsteins's (1996).

Another research to empirically prove the connection between the amount of debt and the market competition is Kovenock and Phillips (1995). They analyzed recapitalization of firms in highly concentrated industries and concluded that low-productive firms are more likely to increase debt and this fact leads to the overall decrease in output of the whole industry. Moreover, they included a discussion concerning agency costs, which can influence the optimal choice of investment, disregarding changes of capital structure itself. Managerial compensation is a crucial issue while talking about the choice of capital structure and investment, so contracts that lack special issues about demand and cost conditions, “…, leverage may act as a way tо cоnstrain managers frоm pursuing aggressive policies in downturns, when these pоlicies may desirable under mоre favorable market conditiоns” (Kovenock, Phillips, 1995).

An alternative approach of analyzing debt and market competition was presented by Grimaud (1999). His main concern was about the design and renegotiation of the financial contracts, which were taken as endogeneous in previous studies, which mainly concluded that debt has negative effect on the market position of the firm. The revision of the contracts allows firms to gain more profit for its own development from the creditor by creating good reputation, for instance by giving back collateral assets or providing additional funds for development of the company. In this article renegotiation-proof is possible both at the interim and ex post stages, this leads to the change of the firms' behavior in a less aggressive way associated with the amount of the default and benefits of good credit reputation. Though, when renegotiation is undesirable (or impossible), the amount of debt has no effect on strategic choices of output and firm interaction.

Work presented by Maksimovic (1991) took into consideration not the single-firm model, but rather the industry as a whole, its overall amount of debt and the competition inside. He came to a conclusion that riskiness of the projects chosen and thus subsequent cash flows is dependent on the decision of all the firms in an industry. This result is achieved only when frims are adopting nearly the same technology of production and thus is hedged against sufficient negative changes in costs. Another point concerns corporate tax rate and choice of the riskiness of project, the more risky is the project, the less of the debt is adopted as corporate tax rate increase, and vice versa. Moreover, individual firms are indifferent between choosing high debt levels and high-risk projects and low debt levels associated with low-risk projects, as tax shield advantage is compensated with more certain future cash flows.

One of the first ones to conclude the dependence of product and financial markets were Brander and Lewis (1986). They proved that limited liability effect will influence firms' behavior and these firms may anticipate changes associated with changes in capital structure, and thus output and leverage are interrelated. Nevertheless, the analysis is lack of such important points as principal-agent problem, tax shield advantage, bankruptcy possibility. And finally, capital structure is industry specific, depending on the model of competition inside.

The industry specification is one of the crucial variables that affect capital structure. MacKay, Phillips (2005) concluded that industry effects influence every firm inside, including choice of technology and risk, which are simultaneously chosen. Other firms in an industry can change their leverage and these changes are interrelated among peer companies. This simultaneity leads to the effect on the capital-labour ratio, leverage, cash flow riskiness.

Thereby, the first researches created a powerful base for further insights, by proving not only the dependence of capital structure on competition and market power itself, but analyzing different sides of the question including agency costs (such as limited liability effect), types of competition in the industry, firms interrelation inside an industry, etc. The basic conclusions state the positive relation between leverage ratio and the amount of output produced, which leads to higher market share. Initial industry concentration also takes place. Nevertheless, cultural, political and institutional reasons may put under the question the results obtained, either partially, or get completely new and unexpected conclusions. That is why it is crucially important to consider each country (or region) and non-financial reasons that may be relevant to the analysis.

New wave of researches support the previous results obtained. Now, as the basic theory is created, scholars started analysis of country-specific issues connected with the choice of capital structure and product market competition.

Guney, Li, Fairchild (2010) provided such a research in China. They analyzed 12 industries during 12 years and concluded that earlier results are still reliable, as leverage ratio and the amount of debt are industry specific and mostly depend on the technology of production and the firm concentration inside, which supports the `deep purse' theory. Speaking about country-specificity, equity financing is more popular among Chinese companies, as long as the fact that most of the listed companies in Chine are state-owned. Creditors are relatively unprotected and there is the stock market share price movements are unclear, so all this facts lead to the reverse pecking order effect.

Another research provided by Sarkar (2013) pointed that firm's cash flows are determined by the amount of output produced, which depends on the aggregate demand for the product, the higher the demand, the higher is the output produced, and vice versa. The main conclusion of the paper is that market power has positive relationship with leverage ratio of the company. Also, Sarkar took into account the capacity of plants and firms' debt decision: when a company produces at full capacity, the market power effect on capital structure is irrelevant, while below full capacity the relationship is positive (as concluded above).

Similar results were obtained by Mitani (2013), based on a sample of Japanese companies. The author expanded the basic interrelation of capital structure and market share to the distinction of two types of competition, in Cournot or Bertrand manner. In both cases leverage and market share are positively related, while the opposite is not true, market share negatively affects leverage, possibly due to competitive advantage of those with high market share, if agency costs outweigh the strategic benefit of debt. Moreover, capital structure is in equilibrium if agency costs are equal the strategic benefit of debt.

Cestone (1999) analyzed the possibility of predation and the ability of the firm to meet its obligations. She stated that financial structure signals to competitors, as well as all players in the capital market, the firms' “success” and the possibility of aggressive behavior. Also, the lender matters: the common one will lead to a collusive outcome. Considering R&D of the industry, it is quite obvious that firms are unwilling to share information concerning the technology of production. Nevertheless, if firms have a common lender (bank, etc) and if it acts as a market player, then it should find it better to share the knowledge among firms, due to having the right to get the disclosure of information of its borrowers. Thus, collusive outcome is very likely to happen, leading to interchange of information concerning technology, R&D and production.

The final article, which is important to point out, is Phillips, MacKay (2005). Authors extended previous researches to the industry and firm specific effects and its influence on leverage. First of all, their regression of leverage on industry medians led to the conclusion that variation in leverage is due to intra-industry specifications and not inter-industry ones. Moreover, the position of the firms, whether it is entrant, incumbent or exiting, is also important in the sense that, even in competitive industries, changes in firms' leverage affect its sector competitors, which leads to interdependence. Firms, that hold their production indices close to the industry-median ones, are less indebted, than firms that move away in either direction from the medians.

1.2 Choice of capital structure

Firms choice of capital structure depend on many factors such as business risk, tax exposure, management style, even cultural peculiarities and economic stability of a particular country.

First, an one of the most important issues affecting financial leverage choice is the fact that interest payments are tax deductible. Tax shield helps to protect a part of income from taxes, so is an argument for increasing the amount of debt.

The stability of a company, its cash flows and market conditions is another factor that makes a company attractable to potential creditors. If a company shows good performance and nothing can potentially cause any disturbance, then investors will not be bothered by firms' solvency.

Management style is one of the factors that affect both capital structure and competition as well. Managers behave in different styles and under different incentives. Aggressive style of management leads to higher debt level, and conservative - to lower one. Moreover, agency costs, such as principal-agent problem, debt overhang, asset substitution, etc, also have an impact on the performance of the firm.

The faster is the speed of growth of the company, the higher the amount of borrowed funds, as usually growth if financed by debt. Though, unlike mature firms, new and actively growing ones' revenues are unstable and unproven, which may lead to higher risk for creditors.

One of the crucial issues to consider while choosing leverage level is market condition. When investors are concerned about future economic situation, it may be difficult and expensive to raise funds. Interest rates may be too high for a company, and the decision to delay the execution of projects until the normal market conditions will take place.

One of the broad researches concerning the choice of capital structure was conducted by Fan, Titman and Twite (2012). They analyzed data of almost 40 thousand firms from 39 countries for the period 1991-2006, and concluded that industry itself has no significant effect, rather the country in which the firm is from has a significant impact. Specifically, corruption, taxation, legal system, and firms' creditor preferences explain the choice of leverage. Taxation effect is as explained by theories: the higher the advantage of tax shield, the higher the level of debt. The main contribution of the article concerns mainly the legal system and corruption, as the corrupted countries tend to be more indebted and the debt is mainly short-term.

Another research, which focused on Asian companies was provided by Driffield and Pal (2010). The analysis was based on the period before, during and after Asian crisis 1997-1998 and on seven countries and was meant to show capital structure adjustment. The results were quiet predictable, as firms with lower levels of debt were hit by the crisis much lesser than those with high leverage and recovered from the crisis faster; firms with access to equity financing and tough regulation have lower leverage levels. The last important point was that companies that finance themselves with equity-like liabilities are less exposed to the effects of crisis than those which finance themselves mainly with debt.

Hernadi and Ormos (2012) made up a similar analysis, though focused on central and eastern Europe. They analyzed medium-sized enterprizes and came to the conclusion of the rejection of positive relationship between leverage and tax and profitability, which supports the pecking order theory. Moreover, business risk is not relevant and has no effect on the amount of borrowing. Finally, they have found the support of pecking order and agency theories in the sense that there appears to be hierarchy in capital structure.

Capital structure is based not only on financial analysis, but also on cultural, political and judicial issues. One of the articles, which tried to explain this connection, was provided by Li, Griffin, Yue and Zhao, and the analysis was based on foreign joint ventures in China. The first conclusion is that cultural effects on the leverage of these ventures a priori. Then they stated that embeddedness and mastery are key determinants in choosing capital structure, and they showed that mastery has negative direct effect on short-term debt decisions, and positive on long-term debt. Embeddedness has only significant indirect effects significant. Overall, their research provides an economic proof of significance of the national culture of foreign joint ventures in China, as informal institutions' influence lead not only to non-optimal choice of capital structure, but also on the size of firms and geographical location, which in turn affect financial leverage.

Another article about Chinese market environment is by Bhabra, Liu and Tirtiroglu (2008) who provided a robust analysis of almost all listed firms in China, and found out that, despite phenomenal growth of at least 10% per year (the period taken was 1992 until 2001) and increasing trading activity, the long-term debt comprise less than 10% of total capital structure. This is due to restrictions provided by the Chinese government, as most non-listed firms are owned by it, and the resulted illiquidity and lack of transparency. Another important finding concerned the source of debt: almost all of it was issued by banks as other creditors such as insurance companies and pension funds did not even exist in the period selected. Finally, the non-formal personal relationship and reputation affected the lenders and borrowers, which is quiet predictable as informal connections are very important and widely used in Asia and particularly in China.

Alternatively, Bancel and Mittoo (2004) concluded that European and the US companies use similar factors while choosing financial leverage. The countries' legal system, as well as cost of capital, explain differences between different capital structures, particularly, the institutional environment influence the factors related to debt more than those of equity. In addition, firm's growth opportunity affect policy about common stocks. Moreover, firms can alleviate the bad quality of the legal structure in the home country by adopting strategies in choosing capital structure, as firms in countries where civil-law are interested to maintain debt-to-equity ratio than those in common-law countries. Also, their research proved the commonly known conclusions such as less concern of large firms of bankruptcy costs, firms with high growth opportunities find that common stock is the easiest and cheapest source of funding. The optimal capital structure is determined by the balance between tax shield, the probability of bankruptcy, agency costs and the availability of external funding.

As equityholders are the owners of the company, they are looking for maximizing their claims, as a result, minimizing the claims of government (through taxes), debtholders and claimants in case of default. Leland (1998) stated that all these claimants deal with the choice of optimal structure. He adds to the analysis the well-known result of Modigliani and Miller (1958, 1963) which states that the default costs and taxes are relevant to the choice of financial leverage, and asset substitution effect presented by Jensen and Meckling (1976), which stressed the significance of bondholders' claims in the choice of the optimal amount of risk. Assets substitution may take place even when no agency costs arise. The relationship between agency costs and leverage though are positive.

One research, which discussed the choice of borrowing from either public investors or financial intermediaries (banks, pension funds, etc) was provided by Lin, Ma, Malatesta and Xuan (2013). They analyzed a commonly known fact that due to the separation of ownership and control managers may be observed in risky activities while using external debt (moral hazard), thus monitoring from the creditor's side is highly undesirable. The conclusion was the following: the higher the divergence of owners and managers, the more reliable are the latter on public debt than on bank financing, which is true especially for family-owned companies, firms that have high probability of financial distress and is less expressed in the firms with a lot of large owners who have strong rights. The main result is that the ownership structure has an immense influence on the choice of financial structure.

A lot of articles discussed the choice of maturity of debt, the prevailing one presented by Kane (1985) which stated that the maturity falls as the effective tax rate rises, and companies choose between advantages of tax shield and the probability of bankruptcy. Speaking about Chinese companies, An (2014) provided an analysis of a new Corporate Income Tax Law (from January 1, 2008), which unified taxes for foreign investment enterprises and domestic ones. The result is as predicted by most of similar articles, taxation is important in the leverage choice, and this fact may be extrapolated to other countries and companies.

The Chinese government is constantly trying to control all parts of financial markets, including availability and the amount of funds, which companies can borrow. This fact is proven by Pessarossi and Well (2013) by the analysis of 220 firms between 2006-2010. First of all, they provided the analysis of corporate bond market, and concluded that this market is in its infant stage, as the issuance of bonds is regulated by the National Development and Reform commission, which is highly conservative and allows the issuance only to a few firms, choice of which is very cloudy as the favoritism is still a part of Chinese politics. Another important conclusion concerns the non-financial nature of debt choice, as firms are limited in debt sources, the main of which still remains a bank loan. The future development of the financial system is China is very vague, though after the reform of 2007 the government intervention in the issuance of corporate bond should be limited.

Booth, Aivazian, Demirguc-Kunt and Maksimovic (2001) provided the analysis of 10 developing countries by testing the factors that influence capital structure in developed countries. They concluded that these factors are similar among two data sets, as well as the negative relationship between profitability and leverage of companies, which is consistent with pecking-order hypothesis.

1.3 Agency costs and information asymmetry issues

Choice of capital structure is based not only on financial determinants, but also on agency costs and information asymmetries. Since ownership and control are usually separated among firms, this can lead to moral hazard, that is the undesirable behavior of managers with respect to shareholders. There are a few dominating theories concerning this subject, though multiple researches either confirm theoretical outcome, or refute ideas developed.

One of the most significant ones is the work presented by Myers and Majluf (1984) stating that managers will use internal resources first and then turn to external financing. After the inside funds are exhausted, managers will issue bonds (or other debt instrument) as it is cheaper in respect to issuing equity until it reaches a point where further debt issuing threatens possibility of bankruptcy. After, equity is issued, though this usually happens when managers think that stocks are undervalued. These actions also act as signaling to market players, whether the firm is strong enough to meet necessary financing internally, or fixed interest associated with debt.

Another theory concerning signaling was created by Ross (1977) who concluded that valuation of firms' stocks depend on the amount of debt firms issue as it signals the good forecast for the company and helps to distinguish between `good' and `bad' firms. Moreover, only management knows the quality of their firm, and thus investors should be careful while choosing a company to invest in. This theory is also proved by John (1987).

The most significant work on this theme was presented by Jensen and Meckling (1976), who provided the analysis of agency cost of outside equity and created the idea of asset substitution effect. In the first part they concluded that managers, while providing effort and having a share in the company, produce much effort and thus costs, and this fact leads to a lower effort from managers' side resulting in lower value of the whole company. The other part of the article concerns the so called assets substitution effect or risk-shifting. This problem arises due to potential conflict between borrowers and creditors. After being provided with funds, management may decide to enter ex post into profitable, but highly risky projects, not negotiated previously, thus increasing shareholders' value shifting risks to creditors.

Agency costs and asymmetric information issues are unavoidable as long as perfect information among market agents is only a theoretical thing, and so capital structure and value of the firm depend on non-financial measures as well. A lot of researches were made with respect to this problems. Kim and Sorensen (1986) concluded that agency costs indeed take place as firms' with substantial inside ownership debt ratio is higher than of those with small one. Also, agency costs decrease with the more concentrated the structure of ownership is, as well as high-growing firms and risky firms in operating terms use less and more debt accordingly. capital financial market competition

Another analysis concerning assets substitution effect was made by Burkhardt and Strausz (2009). They wanted to analyzed the effect of accounting transparency on risk shifting by comparing historical cost accounting and new GAAP regime, and they concluded that despite positive social effects of transparent accounting it leads to heavier asset substitution effect which even overrides these positive consequences for financial agents.

1.4 Business environment in China

China is one of the biggest economies in the world with total GDP equal to 11199,15 bln US dollars (according to tradingeconomics.com in 2016) and the biggest country in the world with population 1,414 bln people (http://www.worldometers.info/world-population/china-population/), and expecting both indices to rise in the foreseen future. These two facts lead to the continuous increase in the number of firms and total demand for the goods produced, thus I have chosen this country to analyze due to the bright future for technologies. The Chinese government has recently announced the 13^th 5-year plan for the development of science and tech industries, especially in environmental protection and robot industry development, alongside with the politics of “in China for China”, makes China the most attractive country for the future technologies.

Due to recent researches, China is a leading country in creating patents, and is on the way to become the largest spender in R&D and innovations (according to 2016 Global R&D funding forecast). Moreover, these new inventions are low cost as technological firms get the support of government and has access to existing solutions in reducing costs. The 5-year plan's industries to support are VR/AR, cloud computing, 3D printing, industrial robotics, NEV (new energy vehicle).

Speaking about researches, conducted with respect to financial environment in China, the one of Cai and Liu (2009) should be mentioned. They analyzed the effect of competiton on tax avoidance activities, and concluded that the poorer is the organization of an industry, the higher the probability of a firm to enter the undesirable behavior concerning taxation, in particular tax avoidance. This happens due to the willingness of companies to gain as much market share as possible, no matter what methods are used and consequences such behavior can lead to. Recommendations given to regulators include improving tax enforcement and regulation of financial markets, especially in highly competitive industries.

The cultural peculiarities of a particular country has an impact on all parts of ordinary life, political management and entrepreneurship features. The tradition of gift-giving is a very old one, and still is significant part of relationship between people, especially those of significant ones, known as guanxi (good connections). Nevertheless, gift-giving and bribery are different concepts while speaking about business environment in China. The article presented by Steidlmeier (1999) observes this traditions and gives guidelines for doing business in this country. He states that doing business in China is quiet an opaque thing, as government influences all parts of financial and political structure, in addition with the fact that corruption and bribery are endemic in Chinese history, thus purely ethical entrepreneurship is almost unachievable.

Having guanxi is a very old tradition and is very important for every person who wants to do business in China, no matter if you are a native citizen or laowai (a foreigner). Some scholars consider quanxi as inalienable part of business transactions, others think that it is a highly unethical and an obsolete notion. Dunfee and Warren (2001) concluded that a lot of forms of guanxi exist, thus having different influence on the actions they are faced to. Speaking of companies, this practice should be critically evaluated and not taken for granted as this is one of the factors that discourage the emergence of financial system and business environment as a whole.

Tsang (1998) proved the fact that having guanxi gives a competitive advantage to firms while increasing market share, negotiating better conditions or even have connections with a regulator. As most articles are written aiming to help foreign managers adequately and successfully do business in China, the facts observed may be used for making conclusions of the effect of guanxi on Chinese companies. One of them is guanxi should be sustained and regularly reviewed for having benefits, as this sustaining has costs such as gift-giving, expensive services, etc. As China is now facing towards market economy from the central oriented one, the effect of guanxi may be reduced, though cultural features are remained very strong and thus guanxi should always be taken into account when speaking about competition of firms and doing business in China.

Xiaohe (1997) argues that business ethics is subject to development due to the immense growth of the Chinese economy and the consequences it brought, such as wealth inequality, corruption and bribery, unemployment, etc. As China faces the increase of the interaction with other countries and cultures, usual norms of doing business will be changed for convenience of multinational interactions. Though, ethical difficulties caused by cultural and historical peculiarities will still take place, maybe in a vague form.

Nevertheless, it still exists and plays an important role in success of entrepreneurship of all kinds in China.

Speaking about future prospect of Chinese economy and business environment foreign companies still have a little to do with regulation inside the country, and thus domestic Chinese companies will not meet excessive competition in the nearest future. According to Bain&Co research, the market of technology with all its branches is expected to grow by 5 or even more percent in 2018. Moreover, accoding to its survey, the barriers which drive down the potential of devepolment in innovation industry is insufficient talent, IP protection and restrictions concerning data security, proving the fact that this and related industries have almost no restrictions in policies and financing.



Chapter 2: Methods and Variables

2.1 Research design

I analyze the relationship between product market competition and leverage in listed firms in China and partly from Hong Kong. For the research I chose an unbalanced dataset of a sample of 3,461 company-year observations from the technological industry, particularly the filter was “technology hardware & equipment”. The period was 9 years, from 1998 to 2017, and the data was collected from Thomson Reuters Eikon. Firms with incomplete data (lack of either balance sheet or income statement) were excluded, as well as brand new ones with existence of a few years. Table 1 shows the composition of data. My methodology is as follows: first consider the overall data, including descriptive statistics and variable definition, then use pooled OLS estimation, after check whether fixed or random effect model is appropriate.

Table 1
Panel data structure.
industry type	# of firms	# of observations	# of years
technology hardware&equipment	314	3 461	9

As far as I want to check whether the relationship between market competition and leverage exist, the main hypothesis is the following:

Hypothesis 0: there is no significant relationship between competition and financial structure of the firm among technological firms in China

Hypothesis 1: there is significant relationship between competition and financial structure of the firm among technological firms in China

Then the results achieved will be compared with already existing ones, and based on the theory, inference will be made on the existence of any effects, such as limited liability effect, pecking-order effect, etc.

Due to the nature of my main hypothesis, the main dependent variable will be capital structure, and the independent one will be an index, which measures product market competition. Capital structure may be defined in different ways, depending on the purpose of a research, though in our case debt ratio is defined as total debt over total assets.

Market competition can also be measured differently, including such indices as Herfindahl-Hirschman Index, Lerner's index and Tobin's Q. As well as with capital structure measure, each index is appropriate in different situations, and for my case Herfindahl-Hirschman Index is more appropriate, as it is the basic and one of the most widely used measures as it shows the market concentration and as a result market competitiveness, that is if the industry is a monopoly, an oligopoly, or firms act in purely competitive market.

Speaking about additional variables in my model, I will include those showing profitability, size, the ability of the firm to generate profit with respect to revenue, that is financial health, cash and net income.

First of all, I need to define the independent variable, as said earlier it is Herfindahl-Hirschman Index HHI, which shows the structure of the competition inside industry. The formula for HHI is the following:

From the formula one can infer, the higher the HHI, the closer the industry structure to a monopoly, the higher the concentration and the lower is the competition, and vice versa, HHI close to 0 describes the market as almost perfect competition. Moreover, this index is highly useful while regulating markets and creating antitrust laws, for instance after M&A transactions HHI can increase dramatically, and the regulator itself can predict the outcome.

Table 2
Annual observations of HHI.
year	HHI	year	HHI
1998	663,478	2015	582,721
1999	651,774	2016	481,789
2000	484,934	2017	483,462
2001	577,670
2002	414,388
2003	342,734
2004	325,639
2005	292,076
2006	790,542
2007	643,066
2008	605,368
2009	554,118
2010	530,128
2011	501,396
2012	673,724
2013	612,165
2014	598,627

Table 2 shows the HHI index for each year of the sample. As can be seen from the data available, HHI index was quiet stable for the total sample of years, showing the industry to be a competitive marketplace, with mean of 549,29 (see table 5). Further fall may be forecasted, which is quiet obvious as technological industry is very attractive to the potential entrants due to high diversity of branches to develop in, as well as increase in aggregate demand for technological products all over the world. Moreover, tech firms have support from the Chinese government, and future of this industry is bright and profitable.



Table 3

Annual dynamics of HHI graph.

There exist contradictory results concerning the relationship between profitability of the firm and its leverage, some of the researchers (such as Brander, Lewis (1986)) consider it to be positive as the ability of the company to generate enough income to cover interests associated with high levels of debt leads to good credit ratings and thus the willingness of companies to increase leverage. In my model I use return on assets ratio (ROA) calculated as net income over total assets.

Same thing happens to the size of the firm, as on the one hand big firms accumulate big earnings and thus can meet their obligations, and on the other hand the amount of information produced enables these firms to attract more equity financing while trading on exchanges. I use total assets as a measure of firms' size.

While analyzing balance sheets of technological companies, I noticed that the amount of depreciation and amortization is tiny with respect to even the R&D expenses, so the commonly known index EBITDA is almost equal to EBIT, with difference of 0,1 to 1,0. For simplification purpose I use EBIT for calculating ratios and further analysis.

Financial health of the company is one of the determining issues to consider while deciding about the choice of financial structure. EBIT margin is the correct criterion, as it excludes interest and tax expenses and in this way managers can conclude about cash flow available to meet obligations. Moreover, this measure can show the effectiveness of operations inside company, and the ability to manage expenses effectively.

Table 4 represents the summation of information about variables with brief description.

Table 4

Definition of variables.

variable	symbol	definition
dependent variable:
capital structure	debt_ratio	total debt/total assets
independent variables:
return on assets	ROA	net income/total assets
financial health	EBIT_margin	ebit/revenue
HHI	HHI	squared sum of individual market shares
cash	cash	cash and cash equivalents
net income	net_income	net income as shown in balance sheet
total assets	total_assets	total assets as shown in balance sheet

Descriptive statistics for all variables is represented in table 5. Since the panel data is analyzed, the extended version of descriptive statistics is used, including the separation of between and within variation. As seen from the table, most of the variation in each variable is determined by within variation, that is the change is in the particular firm than the difference between firms. Speaking about mean values, debt ratio is about 45% which is typical for Chinese firms as, as analyzed earlier, the stock market is its infant state in China, the availability of public debt is limited and thus banks are the only sources of debt.

ROA is nearly 6%, which shows the profitability of firms, though it still can be higher in the future, as nowadays R&D expenses take a significant percentage of overall expenses. EBIT margin is 8,2% which proves the profitability of firms, nevertheless with further development of the industry both ratios are subject to improvement. Net income figure shows 17 mln U.S. dollars, thus providing additional evidence for profitability.

Concerning correlation between variables, the Pearson correlation matrix is presented in table 6. The expected signs of the correlation are as predicted by the matrix. ROA correlation with debt ratio, EBIT margin, total assets and net income is significant, representing the negative relationship between ROA and debt ratio, that is the higher profitability leads to lower is leverage. This result is proved by significant correlation between EBIT margin and debt ratio.

Positive relationship is between ROA and EBIT margin and net income, concluding the obvious result of high profitability. The most interesting coefficient is between net income and total assets, as the higher amount of total assets lead to higher net income.

Table 5

Descriptive statistics.



Table 6

Correlation matrix.

*denote significance level 5%; number below is p-value

2.2 Regression analysis

Now I want to check for any relationship between product market competition and financial leverage of a firm. The main question is if any relationship exist and whether it is positive or negative. The variables are defined earlier, the model used is the following:

, where is for intercept, is for estimated coefficient of variable i , for error term.

The regression results are presented in table 7. Fixed effect model was chosen after conducting Hausman specification test for the difference between fixed and random effect models, and after comparing chi-statistics fixed effect model was chosen. Due to different results obtained in two models, the inference about the importance of model specification is made. In both pooled OLS and fixed effect models the relationship between HHI index and debt is positive, though in the latter it is significant at 5% significance level.

Table 7

OLS and fixed effects results.

	OLS pooled		fixed effects
constant	.4789015* (.0387661)		-
ROA	-1.579194* (.0663211)		-1.539657* (.0683405)
ebit_margin	.0663936** (.032857)		.1252145* (.033339)
net income	.0008037* (.0001931)		.0008105* (.0002105)
cash	-.0002081* (.0000583)		-.0002148* (.0000612)
HHI	.000078 (.0000692)		.0001404** (.0000655)
total_assets	.0000407* (.0000109)		.0000234** (.0000114)
	0.1718		0.1681

*significant at 1% significance level; **significant at 5% significance level; standard errors are in parentheses

The coefficients of ROA, EBIT margin and net income are positive and significant in both models, and thus one can say that as profitability rises, the debt ratio increases.

Coefficient concerning size of the firm, total assets is also positive and significant, stating the fact that larger firms increase this financial leverage. Nevertheless, cash coefficient is negative, despite the fact that cash is part of assets, it contradicts the result of positive relationship between size and leverage.

The relationship between leverage and industry competition is possibly non-linear, so this should also be checked. The model stays the same as for linear one, by exception of adding one additional variable - . The results are represented in table 8. As one can see in both model specifications the non-linear relationship is positive and significant and thus we can infer the U-shaped kind of leverage and competition. Nevertheless, is a bit less than previously giving 12,68% of fixed effect model (which is more appropriate due to panel data characteristic of data).

Table 8

OLS and fixed effects results for non-linear relationship.

	OLS pooled		fixed effects
constant	1.053539* (.0746329)		-
ROA	-.5609033* (.0428059 )		-.3773186* (.0390023)
ebit_margin	-.0817092* (.0236308)		.0162833 (.0216983)
net income	.0000311 (.0001194)		-.0001082 (.0001155)
cash	-.000134 * (.000036)		-.0001162* (.0000335)
HHI	-.0023218* (.0002837)		-.0012597* (.0002515)
HHI^2	0.00000222* (.00000266)		0.00000127* (.000000235)
total_assets	.000055* (0.0000672)		.0000389* (.00000625)
	0.1360		0.1268

*significant at 1% significance level; **significant at 5% significance level; standard errors are in parentheses

Conclusion

In this paper I have analysed the unbalanced panel dataset made up of financial statements of 314 companies of technological industry in China, containing 3461 observations during the period from 1998 to 2017. I wanted to check whether any relationship between financial leverage and industry competition exist, by having debt ratio as dependent variable, a measure of leverage, and HHI index as the main independent one, measuring the structure of the market. Then the variables were tested by using OLS and fixed effect methods. After I decided to check whether the non-linear relationship exist by using similar methods.

The results for most of variables are model specific, though the coefficients for HHI index show positive and significant nature in models, both linear and non-linear.

Due to the importance of technological firm industry for the Chinese economy, my results are important in analysing the features of technological firms. As the area of technology will develop, further corporate finance analysis will be conducted.



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