This document summarizes research presented at the Global Finance Conference in Chicago in 2012 on the relationship between equity financing capacity and future stock returns in China. The researchers investigated how the ability of Chinese firms to issue equity, as determined by regulations set by the China Securities Regulatory Commission, impacted subsequent stock performance. They found that for firms qualified to issue shares, having the capacity for rights issues or public offerings was strongly negatively correlated with future returns. This relationship held for qualified firms that both applied to issue shares and for those that successfully issued equity. The results support theories that predict investors react negatively to equity issuance due to agency problems, signaling effects, or earnings management.

1. Equity Financing Capacity and Stock Returns:
Evidence from China
Lalith Samarakoon
University of St. Thomas, St. Paul, Minnesota
M. M. Fonseka
Xi’an Jiaotong University, China
Gao-liang Tian
Xi’an Jiaotong University, China
Global Finance Conference – Chicago
May 23-25, 2012

2. Research Objective
 Chinese firms have to meet specific requirements set by the
China Securities Regulatory Commission (CSRC) to become
eligible to issue equity and debt securities.
 Once eligible, they have to apply and obtain approval from
CSRC for issuing securities.
 CSRC effectively defines a firm’s capacity to issue equity.
 Investigate whether the equity financing capacity is related to
future stock returns.
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3. Contribution
 Unique setting where the capacity to issue equity is determined
by the regulation.
 Focus on the relation between the capacity to raise equity and
stock returns rather than the relation between actual financing
activities on stock returns.
 Very little previous research.
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4. Literature
 Neoclassical investment theories
 Ability to raise equity capital provides the firm with financing
flexibility and enables it to exploit positive NPV investment
opportunities and increase shareholder wealth.
 Predict a positive relation between capacity to raise equity and
future returns
4

5. Literature
 Agency, signaling, and earnings-management explanations
 Agency : managers-shareholder conflicts may lead to the
overinvestment problem - investing in unprofitable projects
resulting in negative NPV and loss of shareholder wealth
(Jensen 1986, and Jensen and Meckling 1976).
 Signaling: Firms issue equity when they are overvalued and the
market reacts negatively (Meyers and Majluf 1984, Loughran
and Ritter 1995, 1997, 2000, Ritter 2003).
 Earnings management: Firms manage their earnings to increase
financing proceeds. Investors recognize earnings management
resulting in price decline subsequently (Cohen and Lys 2006,
Dechow, Richardson, and Sloan 2008, Papanastasopoulos et al.
2008).
 Predict a negative relation between equity financing and future
returns.
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6. CSRC Requirements for Equity Issuance
6
Date Rights Issues Public Issues
1993/11/17 2 years’ of profitability
Not permitted.
1994/10/30 3 years’ of profitability and 3-
year average ROE ≥ 10%
1996/01/24 ROE ≥ 10% in each of the
previous 3 years
1999/03/17 3-year average ROE ≥ 10% &
ROE ≥ 6% in each of the
previous 3 years.2000/04/30 ROE ≥ 0% in each of the
previous 3 years
2001/03/15 3-year average ROE ≥ 6% 3-year average ROE ≥ 6%
2002/07/24 3-year average ROE ≥ 10% &
ROE ≥ 10% in the previous
year
2006/05/08 ROE ≥ 0% in each of the
previous 3 years
3-year average ROE ≥ 6%

7. Data and Sample
 All non-financial companies listed in China and contained in
the China Stock Market and Accounting Research (CSMAR)
database.
 Data sources: CSRC (announcements), CSMAR (financials),
RESSET (returns).
 Period: 10-year period from 2000 to 2009
 The final sample consists 10705 firm-year observations
representing 1563 firms (unbalanced panel).
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8. Qualified
Issued
Not
Issued
Applied
Not
Applied
Total
Sample Unqualified
Not
Issued
Issued
Not
Applied
Applied
Test Variables
8

9. 9
Sample Category Rights Offers
Only
Public Offers
Only
Both Rights
& Public Offers
Neither Rights
nor Public Offers
Total
Qualified 3,888
(971)
2,514
(911)
2,058
(261)
2,245
(1044)
10,705
(1563)
Qualified for Rights Offers and Applied 213
(207)
49
(48)
10
(10)
5,674
(967)
5,946
(1232)
Qualified for Public Offers and Applied 137
(133)
100
(98)
10
(10)
4,325
(931)
4,572
(1172)
Unqualified for Rights Offers and Applied 203
(197)
51
(50)
20
(20)
4,485
(1015)
4,759
(1282)
Unqualified for Public Offers and Applied 130
(126)
101
(100)
20
(20)
5,882
(1117)
6,133
(1434)
Applied for Rights Offers 416
(404)
100
(98)
30
(30)
10,159
(1031)
10,705
(1563)
Applied for Public Offers 267
(259)
201
(198)
30
(30)
10,207
(1076)
10,705
(1563)
Qualified for Rights Offers and Issued 197
(197)
42
(42)
0
(0)
5,707
(993)
5,946
(1232)
Qualified for Public Offers and Issued 126
(126)
85
(85)
0
(0)
4,361
(961)
4,572
(1172)
Unqualified for Rights Offers and Issued 203
(197)
38
(38)
0
(0)
4,518
(1047)
4,759
(1282)
Unqualified for Public Offers and Issued 130
(126)
76
(76)
0
(0)
5,927
(1232)
6,133
(1434)
Issued Rights Offers 400
(394)
80
(80)
0
(0)
10,225
(1089)
10,705
(1563)
Issued Public offers 256
(252)
161
(161)
0
(0)
10,288
(1150)
10,705
(1563)
Table 2: Sample Classifications and Sizes

10. Empirical Models
 Rit = annual stock return
 ROCapi,t-1 = Rights offering capacity
 POCapi,t-1 = Public offering capacity
 ROCapi,t-1 = Rights and public offering capacity
 Controlsi,t-1 = Control variables
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Rit = αi + ROCapi,t-1 + Controlsi,t-1 + εit
Rit = αi + POCapi,t-1 + Controlsi,t-1 + εit
Rit = αi + RPOCapi,t-1 + Controlsi,t-1 + εit

11. Control Variables
 Firm size (SIZE): natural logarithm of total assets.
 Firm’s age (AGE): natural logarithm of the number of years from
the year the firm was established.
 Ownership type (OWN): dummy variable. If the largest and the
control shareholder is the government, OWN takes 1 and zero
otherwise indicating private-owned firms.
 Beta (BETA): systematic risk
 Leverage (LEV): ratio of total interest bearing liabilities to equity
 The market-to-book value ratio (MBV): proxy for growth
 The return on assets (ROA): proxy for profitability
 Tangibility ratio (TAN): (PPE+Inv)/TA; proxy for capacity for
bank borrowing
 Industry-type dummy variables
 Time dummy variable
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12. Table 7. Equity Financing Capacity of Qualified firms
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Model (1) (2) (3)
Rights Issues Public Issues Both
Constant -1.097*** -0.391** -0.767***
(0.164) (0.199) (0.172)
AGE -0.008 -0.018 -0.015
(0.013) (0.015) (0.015)
SIZE 0.031*** 0.016* 0.017**
(0.007) (0.008) (0.008)
OWN -0.001 0.000 -0.005
(0.0130) (0.015) (0.015)
LEV -0.048*** -0.043*** -0.042***
(0.009) (0.010) (0.010)
BETA -0.063** -0.060** -0.030
(0.025) (0.030) (0.029)
MBV 0.026*** 0.022*** 0.028***
(0.002) (0.002) (0.002)
ROA 0.145* 0.166** 0.120
(0.080) (0.084) (0.085)
TAN 0.088** 0.095** 0.137***
(0.035) (0.041) (0.039)
ROCap -0.057***
(0.012)
POCap -0.053***
(0.016)
RPOCap -0.002
(0.019)
N 6,133 4,759 4,303
Adj. R2
0.74 0.75 0.72

13. 13
Qualified Firms Unqualified Firms All Firms
Model (4)
Rights Issues
(5)
Public Issues
(6)
Rights Issues
(7)
Public Issues
(8)
Rights Issues
(9)
Public Issues
Constant -1.374*** -0.823*** -0.707*** -1.175*** -1.071*** -1.093***
(0.198) (0.240) (0.198) (0.167) (0.148) (0.153)
AGE -0.012 0.004 -0.017 -0.007 -0.0085 -0.0092
(0.015) (0.017) (0.016) (0.013) (0.011) (0.011)
SIZE 0.026*** 0.013** 0.014* 0.035*** 0.028*** 0.031***
(0.008) (0.011) (0.008) (0.007) (0.006) (0.006)
OWN 0.029* 0.021 0.007 0.004 -0.002 -0.004
(0.016) (0.022) (0.016) (0.013) (0.012) (0.012)
LEV -0.013 0.032 -0.041*** -0.046*** -0.049*** -0.048***
(0.017) (0.027) (0.010) (0.009) (0.009) (0.009)
BETA 0.129*** 0.143*** -0.070** -0.072*** -0.037 -0.018
(0.034) (0.047) (0.031) (0.026) (0.024) (0.024)
MBV 0.066*** 0.071*** 0.021*** 0.024*** 0.030*** 0.029***
(0.006) (0.006) (0.002) (0.002) (0.002) (0.002)
ROA 0.461** 0.938*** 0.182** 0.208*** 0.116* 0.110
(0.212) (0.272) (0.083) (0.078) (0.078) (0.076)
TAN 0.075 0.034 0.127*** 0.120*** 0.117*** 0.114***
(0.045) (0.060) (0.042) (0.036) (0.033) (0.032)
ROCap -0.327*** -0.119* -0.194***
(0.065) (0.066) (0.046)
POCap -0.004 -0.105* -0.030
(0.060) (0.057) (0.039)
N 5,887 4,425 4,688 5,983 10,575 10,408
Adj. R2
0.70 0.68 0.75 0.74 0.72 0.73
Table 8. Equity Financing Capacity of Applied Firms

14. 14
Table 9. Equity Financing Capacity of Issued Firms
Qualified Firms Unqualified Firms All Firms
Model (10)
Rights Issues
(11)
Public Issues
(12)
Rights Issues
(13)
Public Issues
(14)
Rights Issues
(15)
Public Issues
Constant -1.394*** -0.540** -0.721*** -1.463*** -0.946*** -1.126***
(0.199) (0.246) (0.199) (0.169) (0.150) (0.145)
AGE -0.012 0.003 -0.017 -0.007 -0.010 -0.009
(0.015) (0.017) (0.016) (0.013) (0.011) (0.011)
SIZE 0.026*** 0.012** 0.015* 0.036*** 0.028*** 0.031***
(0.008) (0.010) (0.008) (0.007) (0.006) (0.006)
OWN 0.031* 0.019 0.006 0.004 -0.003 -0.005
(0.016) (0.022) (0.016) (0.013) (0.012) (0.012)
LEV -0.010 0.034 -0.040*** -0.045*** -0.049*** -0.047***
(0.017) (0.027) (0.010) (0.009) (0.009) (0.009)
BETA 0.132*** 0.140*** -0.065** -0.069*** -0.033 -0.017
(0.034) (0.048) (0.031) (0.026) (0.024) (0.024)
MBV 0.066*** 0.070*** 0.021*** 0.023*** 0.030*** 0.029***
(0.005) (0.005) (0.002) (0.002) (0.002) (0.002)
ROA 0.459** 0.948*** 0.185** 0.210*** 0.116* 0.111*
(0.212) (0.275) (0.084) (0.078) (0.078) (0.076)
TAN 0.071 0.029 0.127*** 0.121*** 0.121*** 0.115***
(0.045) (0.060) (0.042) (0.036) (0.033) (0.032)
ROCap -0.341*** -0.108* -0.191***
(0.067) (0.067) (0.046)
POCap -0.017 -0.104* -0.003
(0.050) (0.060) (0.037)
N 5,904 4,446 4,721 6,003 10,625 10,449
Adj. R2
0.70 0.68 0.75 0.74 0.72 0.73

15. Conclusions
 The capacity for rights and public offers of shares is strongly
negatively related with future returns for firms that meet 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.
 Results are consistent with agency, signaling as well as earnings-
management hypotheses, which predict a negative relation
between equity issuance and subsequent returns.
 Further research is necessary to differentiate among competing
explanations for the observed results.
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