Capital Structure Analysis of Tencent Holdings Limited

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Title Capital structure analysis of Tencent Holdings Limited

Yung, Siu Him (翁韶謙); Cheng, Xi (程曦); Wu, Jinting (伍晋葶); Author(s) Cheng, Sau Shing (鄭秀城)

Yung, S. H., Cheng, X., Wu, J., & Cheng, S. S. (2014). Capital structure analysis of Tencent Holdings Limited (Outstanding Academic Papers Citation by Students (OAPS)). Retrieved from City University of Hong Kong, CityU Institutional Repository.

Issue Date 2014

URL http://hdl.handle.net/2031/7486

This work is protected by copyright. Reproduction or distribution of Rights the work in any format is prohibited without written permission of the copyright owner. Access is unrestricted.

CAPITAL STRUCTURE ANALYSIS OF TENCENT HOLDINGS LIMITED

Siu Him YUNG Xi CHENG Jinting WU Sau Shing CHENG

Department of Economics and Finance City University of Hong Kong

2014

City University of Hong Kong

EF 4313 Corporate Finance Supervisor: Yaxuan Qi

Capital Structure Analysis

Tencent Holdings (0700 HKG)

Abstract

Among those listed on the stock exchange, a company is chosen for which a comprehensive yet concise analysis is given in order to assess for that company the needs for raising capital in the short-term and the feasibility of various ways to financing in accordance with classical theories of pecking order, trade-off, and signaling. In addition, an attempt is given to answer whether there is a need for the company to have a change in its current capital structure for investment opportunities identified.

March 2014

City University of Hong Kong EF 4313 Corporate Finance

To my family, friends, and others who have belief in my ability to complete this term paper. Their faith and encouragement helped me overcame difficulties in this final year.

A Term Paper Presented to the Department of Economic and Finance of City University of Hong Kong in Partial Fulfillment of the Requirement in EF 4313 Corporate Finance

March 2014

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Contents Introduction ...... 3 Intr1 Company, Competitors, and Industry ...... 3 Intr2 Capital structure ...... 3 Part A Company, Competitors, and Industry ...... 4 1.1 Business Summary of Tencent ...... 4 i) Product Strategies: ...... 4 ii) Recent Events: ...... 4 a) Investment in Epic Games ...... 4 b) Investment in south-west headquarter ...... 5 c) Merger with JD.com ...... 5 d) Free Cloud Service to US clients ...... 5 iii) Historical Financial Performance and potential financial risks ...... 5 a) Profitability ...... 5 b) Stock Market...... 6 c) Financial risk factors ...... 6 1.2 Competitor Information ...... 7 i) Market Share and Market Capitalization ...... 7 ii) Competitive advantage ...... 8 a) Games service on internet and on mobile ...... 8 b) Large customer’s base ...... 8 c) Wide variety of services ...... 8 1.3 Industry Information ...... 9 i) Possible Determinants of Industry Beta ...... 9 ii) Regulation ...... 9 iii) Revenue model of internet service provider ...... 9 Part B Capital Structure ...... 10 2.1 Capital Needs ...... 10 2.2 Related Literature for Capital Choices ...... 12 2.3 Capital Structure Comparison ...... 14 i) The Company’s Capital Structure ...... 14 ii) Competitor’s Capital Structure ...... 14 2.4 Asset types and Other Factors ...... 16 i) Asset types ...... 16 ii) Additional Notes on Capital structure ...... 17 iii) Additional Notes to Dividend payout ...... 19 2.5 Suggestion ...... 20 i) Dividend payout and fixed capital structure ...... 20 ii) Flexibility of company and fixed capital structure ...... 20 iii) Firm’s beta and fixed capital structure ...... 20

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Introduction

Entities need capital to finance projects and the cost associated with such is a main concern for the management of companies. Capital can be raised either internally or externally; internal capital refers to retained earnings and reserves, while external capital refers to the debt and equity issued for security trading purposes.

Prioritization of methods to raising money depends on the cost of capital and the limitation related to each method. Modigliani-Miller (1958) and the pie model suggest that the way how the pie is sliced does not affect the size of the pie. In other words, the traditional view of shifting around the debt and equity of the firm in order to create value is in this sense infeasible, and thus it seems necessary to have a new approach to capital structure analysis. Hence, a publicly listed company is chosen in this assignment and we aim at answering one question:

“Is the current capital structure of the company appropriate to provide the best source of funding for the existing and future investment opportunities?”

This assignment is, as a consequence of testing the above proposition, divided into two parts:

Intr1 Company, Competitors, and Industry

In Part A, we focus on qualitatives of: i) Tencent [the company], ii) competitors, and iii) industry, together with a list of Tencent’s recent investment projects ongoing that require extra capital. We identified existing opportunities and proceed further to competitor analysis and finally to an overview on Internet-Service-Providers industry.

Started with a brief description on Tencent [the company]’s product and services along with its recent investment projects that may require extra funding raised through a change of its capital structure, we identify, based on the market share and market capitalization, the major competitors of Tencent. We then narrow down the number of competitors to two according to their similarity with Tencent in terms of the nature of products and services. Finally, an overview on the industry is provided to give relevant information on i) determinants of industry beta, ii) regulation on the traffic of internet, and iii) the revenue model of internet service providers.

Intr2 Capital structure

In Part B, focus is shifted towards quantitatives and two questions arisen from the above proposition are answered based on information in Part A together with theories that may shed light on the prioritization of methods to financing and on attaining optimal capital structure. In addition, we analyze the past and current D/E ratio of Tencent and of its competitors as a means to explaining why Tencent has a debt-equity use drastically different from its competitors’. Historical performance of and recent development undertaken by the company are therefore addressed, with an analysis on payout policy and asset types of the company as part of our reasoning. Finally, reasons on increasing debt uses are given, with suggestion of not following its competitors’ policies as conclusion.

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Part A Company, Competitors, and Industry

1.1 Business Summary of Tencent Tencent, which was established in 1998 and listed on Hong Kong Exchanges in June 2004, has now become the leader of Internet Service Industry in Mainland China. In February 1999, Tencent had launched its first instant massager “QQ”, which has made the company become famous and has brought it the first pot of gold. Another highlighted event is the launch of “QQ Games” in 2003 which leads Tencent to be the market leader of the online game sector and Internet Value-added Service Market (“IVAS”). Till 2012, revenue generated from IVAS remains having the largest portion. Later at the beginning of 2011, the free mobile chat tool – ‘Wechat’ came into market and quickly became one of the most widely used IM tools in China, bringing great profits to Tencent. Currently, the company holds a business portfolios consisted of Communications Platforms (QQ), social platform (MAU of Qzone, MAU of friend group, Wechat Moments), media platforms (QQ.com, Tencent Microblog), IVAS subscription services, MVAS, Online Advertising, and e-Commerce Transactions.

i) Product Strategies:

Tencent has established a wide range of mobile application services such as communications, social networking, media, security and browser. As the mobile services market is growing, Tencent continues to invest in developing and marketing independent mobile services such as security product and web browser. For instance, QQ Doctor, a free security software developed by Tencent, is one of the security products currently developed by the company. Another example is the Tencent Traveler, which is a multi-page webpage browser; it makes surfing on the Internet more convenient and less time-consuming. The company also dedicates to improving internet users’ experience by integrating new applications into a newly developed app, WeChat, to leverage the existing social connections.

Tencent has also strengthened the integration of its core platforms to enhance user engagement. Due to the increasing market size of the mobile Internet sector, the company has enhanced the mobilization of PC-oriented platforms to cater for the needs of internet users that are increasing in number.

ii) Recent Events:

Recent Events of Tencent can be summarized into four sub-categories, each of these is said in the next section as investment projects that require extra capital raised either internally or externally via a change in capital structure.

a) Investment in Epic Games In 2012, Tencent continued to invest in companies that can bring opportunities for long-term strategic benefits. Among the company’s investments includes minority stakes purchased in Epic Games, a US-based development team with a long history of creating popular games and a market-leading game development engine; and in Kakao, a leading mobile messaging service provider in Korea.

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b) Investment in south-west headquarter In February 2014, Tencent announced a RMB 1 billion investment in Chengdu Hi-tech Zone to establish its southwest headquarter on the foundation of its customer service and online game R&D centers, with the purpose of running its entire business chain in Chengdu.

c) Merger with JD.com Since March 2014, Tencent and JD.com has formed a strategic partnership to provide superior e-commerce service to mobile and Internet users in China. Furthermore, Tencent agreed to buy 15 percent stake in a Chinese e-commerce website, JD.com Inc., with RMB 214.7 million in cash, aiming to build a stronger competitive edge against Alibaba Group Holding Ltd. Tencent and its partner firm expect to take advantage of the popular online selling market of JD.com and the wide group of users of Tencent to generate bilateral revenue enhancement.

d) Free Cloud Service to US clients Besides, Tencent will start to provide 10TB of free cloud storage to attract US users in early 2014. This new offering will enable the company to compete with its counterparts such as Gox.net, Google Cloud and Dropbox.

In addition, Tencent has participated in a pilot program to providing its own online banking. Utilizing this tool, the company can reduce the cost of loan and better promote its development of economic entity.

iii) Historical Financial Performance and potential financial risks

a) Profitability Table 1.1 Financial Performance of Tencent for year 2009 to 2012 in ,000 HK$ 2009 2010 2011 2012 Revenue 12,440,000 19,646,000 28,496,000 43,894,000 Total cost 7,284,000 11,592,000 18,293,000 31,162,000 Net Income 5,156,000 8,054,000 10,203,000 12,732,000 Profit Margin 41.45% 41.00% 35.81% 29.01%

The table above is a summary of Tencent’s profitability from year 2009 to 2012. The revenue of the company had been increasing steadily from 2009 to 2011 and it soared dramatically after “Wechat” and e-commerce transactions were introduced in 2011. Nevertheless, Tencent did not keep the same growth rate in the net income as it did in the revenue, which can obviously be observed from the decreasing profit margin. This situation indicates the operating functions have become less efficient. Both the nature of the new revenue models and the capital structure switching [capital structure will be addressed in the next section] compose the main triggers of the reducing profit margin.

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b) Stock Market Consistent with its profit performance, stock price of Tencent has been soaring in the past five years due to the economic growth and its expansion in scale. The stock started rising since the early 2009 and has surged from the start of year 2014, followed by an upward drift in price which becomes more aggravated in recent months (Figure 1.1). Records show that Tencent has its stock value increased from around $460 per share to $600 per share in the first quarter of the current year (Figure 1.2), which indicates that investors have high expectation towards Tencent’s ongoing expansion strategies.

Figure 1.1 Stock Price and Trading Volume (in years, from 2009 to 2014)

Figure 1.2 Stock Price and Trading Volume (in months, from Jan to Mar 2014)

c) Financial risk factors As one of the key members of Internet service providers, Tencent is subject to market cyclicality as well as various market risks including foreign exchange rate risk, price risk and interest rate risk. For instance, Tencent had reported a RMB 20.95 million exchange loss in 2012, as shown in its annual report (Appendix 3). Although the company is not significantly affected by commodity price risk, its investment return is highly correlated with interest rates and exchange rates movements. Fortunately, these risks are reducible with a diversified investment portfolio, and interest rate risk from the variable rate of some borrowings issued by Tencent can be reduced through swaps and futures contracts that help fixating the future rate when the contacts come due.

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Apart from foreign exchange, Tencent is also exposed to a medium level of credit risk. Tencent’s recoverability of receivables is subject to its arrangements with cooperative telecommunication operators, which help Tencent to collect part of the service fees from clients, so the operating cycle of the company depends not only on the repayment period of its own clients but also depends on the debt recovering service provided by those operators. This subject the company to some extent to a tolerable level of credit risk which is based upon both the performance of the company itself and that of companies which cannot be all the time controlled by Tencent.

1.2 Competitor Information The following section is to analyze the major competitors of Tencent to examine the major effects that its competitors brought about to the company.

In the selection of major competitors, we use two criteria: 1) Market Capitalization, and 2) Market Share. Market capitalization is measured by the market price of share multiplied by the number of shares outstanding, while market share is information that is not available to the public, so it is estimated through using the revenue of the companies. The reason for choosing these two as criteria is that market capitalization is the measure of companies’ asset value, while the market shares of companies show how competitive each company is when compared with others.

The rationale is that if a company is both large in terms of market capitalization and of market share, then it is likely to be a major competitor of Tencent.

i) Market Share and Market Capitalization

Table 1.2 shows the information of the market capitalization and the market share of companies that are chosen for comparison. Major competitors identified are: i) Baidu, ii) Yahoo, iii) Google, and iv) Facebook.1

Table 1.2 Market Share and Market Capitalization of Companies $’bil $ ‘bil $’ bil $’ bil $’ bil $’ bil

Companies Tencent Baidu Yahoo Google Facebook Total Market Share 37.02% 27.60% 16.33% 13.24% 5.58% 100% Market Capitalization 1134.40 845.80 500.30 405.70 178.00 1929.80 Revenue per year 9.04 7.82 5.04 1.48 1.54 24.92

From above it seems that Baidu and Google are two of the major competitors that Tencent is facing with2. Among all, Baidu has the largest amount of revenue and market price and thus the highest amount of market capitalization and market share at the time of writing. Facebook, on the other hand, has the lowest amount of market capitalization and the smallest market share. Nevertheless, the news that it has announced to acquire Google’s What’s App at a price of $18.89 billion is indicative that the company is likely to explore on the

1 Major competitors identification depends also on the financial information on the US stock market. 22 In Part B when we define competitors, we narrow down the choice to Yahoo and Facebook only, based on reasons later mentioned.

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mobile market, this may be an implication that i) Facebook is likely to be more competitive and thus be one of the major competitors of Tencent, and ii) the mobile app’s market will be flourishing in future as more and more providers are joining.

In addition, the market shares of the five companies3 are not equally spread and this implies that some providers are relatively more competitive than the others (if other factors are not considered). Baidu, for example, is one of the largest competitors if assessed according to market capitalization and market share. In the following part for capital structure analysis, however, we narrow down these competitors into two [Yahoo and Facebook] simply because we find that size is one yet not the most important factor to identifying major competitors and because these two companies [Yahoo and Facebook] are directly competing with Tencent in terms of their nature of products and services.

ii) Competitive advantage

Tencent has the largest portion of market share and also the largest market capitalization as compared to its competitors. Since it is natural to assume that larger companies have more capital and resources than the others, it is normal for Tencent to invest in numerous positive NPV projects and has in future a higher profit compared with its competitors.4 Still, the company has to know its competitive advantages and improve on aspects that can increase its net income. Referring to part 1.1, competitive advantages of the company are summarized as follows:

a) Games service on internet and on mobile The recent moves by the company to seek alliance with foreign game developers such as Epic Games (U.S.) and CJ Games (Korean) will definitely expand the game developing base of Tencent and thereby enable it to further proceed on providing quality services as regard to the mobile graphic platform.

b) Large customer’s base Tencent is well-known in China and it gains advantages from its well-established user base in QQ.com5. Its recent development in the mobile app, when utilizing on the original base of users in QQ.com, is also a major advantage of the company to move further to the development of mobile services.

c) Wide variety of services As mentioned in the first part of this paper introducing the background of the company, Tencent has a wide variety of services including instant messaging mobile apps, online banking, and PC security software such as QQ Doctor. This diversified approach in investment will lower the unsystematic risk of the company and thereby enhance its returns to investment.6

3 For simplicity, only large companies are considered and the five largest are chosen. 4 In part 2 we narrow the competitors analysis to only two of the four identified companies based on the reason that Google had disposed of its instant message application to Facebook and we thus expect Facebook, instead of Google, will be directly competing with Tencent 5 QQ.com is Tencent’s first established platform and has accumulated users of more than 20 million. 6 Diversification alone cannot create value for investors because investors can have their portfolio at desired risk level via a

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1.3 Industry Information

This section outlines the major information of the industry and is divided into: i) possible determinants of industry beta, ii) regulation that affects internet industry, and iii) the revenue model of the mobile app’s business.

i) Possible Determinants of Industry Beta In theory, beta depends on: i) Revenue Cyclicality, ii) Operating Leverage, and iii) Financial Leverage. In reality, however, we think beta depends not only on the three afore-mentioned. In particular, for the industry that Tencent is operating in, we presume that industry beta has to include other factors such as user’s preference, and market trend because companies providing internet products/services generally have high volatility in firms’ investment. An investment made by these companies can either be highly profitable or be suffered from huge losses, depending on users’ preference and other factors. For example, prior to the existence of the now well-known social media network Facebook, there were massive of online platforms providing similar services. Most of them faded out when Facebook was introduced into the market. User preference and market trend are hard to predict, thus it is almost not possible to say for sure whether a particular project is profitable or not.

ii) Regulation Internet service providers’ revenue may be affected if government tightens the law to internet traffic. A recent piece of news reported that internet services are recently regulated by the government and the revenue of the internet service providers were thereby affected7. Likewise, the virtual credit card, a new financial product developed by Chinese Internet information providers, was reported to be stopped by Central Bank of China on March 14th because of the risks it is associated with. Prohibition from the sale of goods or services will definitely dampen the revenue and net income of internet services providers.

iii) Revenue model of internet service provider According to a news article on Wall Street Journal (WSJ), the major business model of internet service providers in the mobile app’s business generate revenue through three sources: i) subscription of on-line accounts for messages that sent out to large number of receivers., ii) sticker features and logos with charges used in the text messages, and iii) add-value service of online video games8. If Tencent is going to explore on the mobile apps market in foreign countries, it has to acquire enough understanding on these revenue sources and match them with the competitive advantages identified in the previous sub-section [part 1.2].

diversification. This notion does not contradict with our argument, however. 4 Moving Beyond the ‘Net Neutrality’ Debate http://blogs.wsj.com/digits/2014/01/14/some-in-tech-industry-moving-beyond-net-neutrality-debate/?KEYWORDS=internet+informati on+provider 8 How Messaging Apps Make Money http://blogs.wsj.com/digits/2014/03/03/how-messaging-apps-make-money/?KEYWORDS=wechat

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Part B Capital Structure

Following the proposition put forward at the beginning of this paper, we in an attempt to examine, in this section, the current capital structure of Tencent and suggest solutions to optimal by answering two questions.

Question 1: Is there a capital need in the company? Question 2: If there is a capital need, should the company use more debt, equity, or both?

2.1 Capital Needs Before analyzing the capital structure of Tencent, we want to know first whether the company has a capital need. We include in this paper both qualitative and quantitative measures to provide the most comprehensive view. a) Qualitative Measures to Capital Needs In part 1.1 we have identified the existing projects of Tencent which are summarized as follows: i) Mergers with JD.com9 and Epic Games ii) Free cloud services provided to US clients iii) The development of online banking iv) Headquarter establishment in the southwestern part of China b) Quantitative Measures to Capital Needs

i) Internal Growth Rate For quantitative measures, we first use internal growth rates to justify external financing needs. Interbal Growth Rate = ROE ∗ b / ( 1 − ROE ∗ b) In past literatures, growth rate is sub-categorized into internal growth rate and sustainable growth rate. Internal growth rate is the rate at which a firm can grow without any external financing, and sustainable growth rate is the rate at which a firm can grow without the use of debt. In this paper, we focus only on internal growth rate for two reasons: i) the two rates are nearly identical in terms of the rate of growth; and, ii) the use of ROE instead of ROA in the equation of internal growth rate better suits with the purpose of this paper where the whole firm rather than only asset of firm is considered. 35.90% ∗ (1 − 14.30%) Internal Growth Rate of Tencent = = 32.43% (1 − 35.90% ∗ 14.30%) The internal growth rate of Tencent is around 32.43%. If capital is to increase proportionally with growth rate, then the company needs an extra 32.43% of liquid assets. This matches with the qualitative finding in part 1.1 that Tencent recently has growth opportunities and thus has capital needs.

In subsection i) of part 2.4 we argue that increase in leverage leads to a higher return on equity. This is to say if a firm increases its plowback ratio, the expected growth rate will increase even further.

9 At the time of writing [26 Mar], there was a news about the investment of Tencent in a Korean software company (CJ Games). We in an attempt to cover all relevant information and give a informative view on Tencent’s capital needs for the subsequent part of the analysis on capital structure.

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In reality, however, using internal growth rate alone leads to biases. Here we see internal growth rate as indicator rather than causes of growth. A firm with high ROE and high plowback is likely to have high growth, but high growth is not necessarily determined solely by ROE or plowback. Part 1.1 identified four investment projects and opportunities of Tencent, and we argue that a firm’s growth depends highly on the positive NPV projects that it undertakes and partially on the rate calculated. Thus, other two measures are considered to justify our reasoning.

ii) External Financing Needs The second quantitative measure for capital needs is the External Financing Needs (EFN). Assets SpontaneousLiabilities EFN = ( ∗ ΔSales) – ( ∗ ΔSales) – (profit_margin ∗ predicted_sales ∗ (1 − d)) Sales Sales

It is normal that if a firm has increases in assets, decreases in liabilities, or decreases in reserves will have higher external financing needs. The EFN calculation assumes that changes in assets and liabilities are in line with and in the same percentage as predicted sales.

EFN calculated for Tencent based on financial information released = RMB 92,552,179 (Appendix A4).

iii) Liquid Asset Balance Third, we use liquid assets on hand to justify capital need. From the annual report 2012, the cash balance of the company for past four years were maintained at around RMB 200 million (the average of four-year cash balance). The firm’s value (measured by firm’s total assets) increased by a hundred percent from 7.2 billion to more than 14.5 billion in 2012. Cash/firm ratio has been decreasing since 2011 and further down to 1.33% in 2012.

Exhibit 2.1 Cash Balance and Firm Value of Tencent [the company] (RMB in thousands) 2009 2010 2011 2012 Cash and Cash Equivalents 102,081 237,525 187,791 165,534 Firm Value as measured by Total Assets 3,513,640 3,791,108 7,240,155 14,538,288 Cash/firm 2.91% 6.27% 2.87% 1.33%

The cash balance of the company has decreased despite that the company has its size increasing from 2011 to 2012. Cash on hand is low and it is necessary for the company to have it increased so as to ensure that there are sufficient liquid assets for normal business operation. In particular, when a firm has largely expanded in size and has invested in new projects [see 1.1] that may require extra funding, it needs to keep its cash balance increasing as well. Thus, we conclude that there is a capital need, and the next question is whether to use debt or equity to have the lowest cost of capital achieved by attaining a capital structure at its optimum.

In the following section [2.2] we review literatures on optimal capital structure and in section 2.3 we examine the current D/E ratio of both Tencent and its competitors’, together with dividend policies and asset types in order to suggest for Tencent the optimal debt-equity mix and the prioritization of capital uses.

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2.2 Related Literature for Capital Choices

Theories on capital structure mainly divided into four realms: i) pecking-order; ii) static trade-off; iii) information asymmetry; and, iv) agency costs. In this assignment, we focus mainly on the first two together with other theories on asset types and growth in guiding us to the optimal capital structure of Tencent [the company].

Tobin (1982) expressed firm investment as a function of growth opportunities10. This is to say firms within an industry where there are much growth opportunities are likely to invest more than firms in industries where there are few growth opportunities. Growth refers to the existing positive NPV projects that enable the firm to either expand its business in terms of scale or to enhance its business efficacy via better technological know-how or better products or services provided to clients. Literatures on the optimal capital structure prescribed factors that a firm should consider when deciding on its debt uses and there is one article written by Titman and Wessels (1988) which summarized all factors into eight items11. We consider two of the eight factors that are useful in determining the capital structure and we in addition combine these two factors with other theories, together with a concise analysis on the capital structure [part 2.3], asset types, and payout policies of competitors [part 2.4], to arrive at a few suggestion on the capital structure of the company [part 2.5].

First, we consider growth of the company. Conventionally, it is said that growth of a company is negatively related to its use of debt due to various reasons (agency costs and the protection of technological know-how in case of not having sufficient cash for repayment). However, Myers (1984) argued that short-term debts and convertibles should be effective in mitigating agency costs and thus there should be a positive relationship between these instruments and growth, with some argued further that the low debt-equity ratio of high growth firms is due much to their high share price but not to the actual amount of debt used [Appendix 1]. In previous parts we have identified some of the investment opportunities and existing projects of Tencent [part 1.1 and 2.1], we thus in an attempt to argue, using this evidence, that Tencent should use more debt.

Next, we turn to other theories in guiding the decisions on a firm’s optimal capital structure. In particular, we focus on pecking-order and static trade-off theory. Pecking order theory [Myers, 1984] suggests that a firm should first use internal funding, then to external; and when it decides to use external funding, it should first go from low risk capital such as debt, and finally to high risk, equity capital. This view by Myers was based on the notion that companies do not want i) to have incurred too much debt that will increase the interest expenses of the company; and, ii) to have its control power being diluted in the increased equity issue. In modern days, however, we see firms issue both debt and equity irrespective of the above concerns. This may be the consequence of companies now have large number of shareholders widely dispersed and only a few large shareholders care about control power [control power can still be maintained via the use of dual class equity as in the case in many US companies, so the intent of control power maintenance should not preclude firms from using equity capital as a source of funding]. Therefore, we dismiss this theory in our analysis while retaining its essential part in the priority of financing methods.

10 The original article of Tobin in 1969 is on the national income of an economy. The later evolvement of Tobin’s q into the investment theory expressed a firm’s investment opportunity in its market-to-book ratio. 11 The eight items (determinants) to the optimal capital structure are: i) asset types, ii) interest tax benefits, iii) size, iv) profitability, v) volatility of income, vi) uniqueness, vii) industry, and viii) growth.

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Another theory in concern of the capital structure is the static trade-off theory which suggests that the firm’s capital structure is maintained through a balance between the benefits and costs of debt. The main benefits from using debt12 includes the interest tax benefits and various behavioral finance issues of equity holders over debt holders, while the main costs from using debt are the direct and indirect costs which are grouped into the costs related to financial distress. The trade-off theory suggests also that a firm should have a target debt-equity ratio and gradually moves towards it [if we have R0, Rd, Tc of all time, we can regress on these and obtain the optimal capital structure B/S.]. This theory is useful in providing suggestion in determining the optimal debt-equity ratio of the company. In part 1.1 we have shown that the revenue of Tencent has been increasing since 2009, but its profit margin was in reverse due to the slow increasing rate in net income. One possible solution to increase net income is to incur more debt so as to increase the funding available to the company. Normally, a company with abundant cash flow will be less hesitate in deciding on positive NPV projects and is likely to grasp all profitable opportunities.

Based on these theories we conclude that the priority of capital use should be on internal then to external, and on low-risk then to high-risk capital. In particular, we focus on the growth argument and the static trade-off theory and as a result thereof suggest that the company should incur more debt so as to get hold of every profitable opportunity. Apart from this suggestion which is based mainly on the internal factors of the company, we add in the following section some external factors such as a comparison between the company and its competitors’ capital structure, their asset types, and their payout policies, together with theories on return on equity (ROE), dividend and signaling, and term structures, which jointly shift our focus to external circumstances together with strategies of competitors which are essential to deciding the optimal capital structure of Tencent.

12 The fine distinction on ‘liability’ and ‘debt’ is an evolvement in finance. ‘Debt’ includes only long-term notes payable, long-term borrowings, and the current portion of long-term borrowings; while ‘liability’ includes all types of debts together with all types of operating leases [finance lease is an asset and lease obligation is a long-term liability, see IAS 17 Leases], obligations, and commitments other than those set out in accordance with IAS 37 Provisions, Contingent Liabilities, and Contingent Assets. In the following section where the capital structures of Tencent and of its competitors are analyzed, we adopt the conventional approach to measuring debt and include all other liabilities into calculation. This may be imprecise in the view of most practitioners, but we still see the inclusion of other payables as debt as more conservative.

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2.3 Capital Structure Comparison13

Prior to the suggestion of an optimal capital structure of the company, it is sensible to consider external factors and compare the existing capital structure of Tencent with its competitors’ to see if there is any notable difference.

i) The Company’s Capital Structure

Table 2.1 Tencent’s Capital Structure, 2012 and 2013 2012 RMB ‘mil 2013 RMB ‘mil

Short Term Debt 20,664,996 27.46% Short Term Debt 33,267,000 31.02%

Long Term Debt 12,442,549 16.53% Long Term Debt 15,505,000 14.46%

Equity 42,148,266 56.01% Equity 58,463,000 54.52%

Total 75,255,811 100.00% Total 107,235,000 100.00%

Table 2.1 shows the capital structure of Tencent is about 50% debt and 50% equity for both year 2012 and 2013. In accounting there is strict definition of liability and items that satisfy three requirements are classified as liability (Murray, 2010), but when following the definition of ‘debt’ in finance and excluding other payable in the calculation, the D/E ratio will be 25.91% for 2012 and 25.75% for 2013. In the case of Tencent, debt in 2012 is 10,700 and is 15,053 in 2013 when other payables are excluded from calculation. However, from Table 2.1 alone we cannot conclude whether Tencent has been adopting fixed capital structure policy.

Referring to the annual reports of Tencent for the decade-change in its D/E ratio, we find that the capital structure of the company changed by a proportion from equity to debt, from debt to equity, and finally settled on the half-and-half capital mix in the last two years. We thus conclude that the company appears to have a flexible debt-equity ratio and there is no apparent target debt level preventing the company from investing in profitable projects [capital structure of the company in the past years is shown in the Appendix].

ii) Competitor’s Capital Structure

Yahoo’s Capital Structure Table 2.2 Yahoo’s Capital Structure, 2012 and 2013 2012 RMB ‘mil 2013 RMB ‘mil

Short Term Debt 8,114,115 7.54% Short Term Debt 8,038,403 7.98%

Long Term Debt 14,130,105 7.06% Long Term Debt 7,522,456 13.89%

Equity 79,491,321 85.40% Equity 90,995,828 78.14%

Total 101,735,541 100.00% Total 106,556,687 100.00%

13 Data is collected manually by one of the group member who is not willing to disclose his name, in great thanks we include the spreadsheet that is prepared by him with this assignment.

14 City University of Hong Kong EF 4313 Corporate Finance

In contrast to Tencent’s well-balanced capital structure, Yahoo Inc. is heavily using equity capital and has less reliance on the use of short-term debt. In respect of target debt-equity ratio, Yahoo Inc. seems to have maintained a invariable D/E of lower than 10% even though its capital size continues to expand throughout a five-year period. While Yahoo Inc. has its debts increasing on a year-on-year basis, its debt-equity ratio is kept at a sufficiently low level. This implies that Yahoo Inc. has been increasing its equity issue simultaneously with its debt issue so as to maintain a relatively fixed debt-equity ratio in response to the changes in external environments.

Facebook’s Capital Structure Table 2.3 Facebook’s Capital Structure, 2012 and 2013 2012 RMB ‘mil 2013 RMB ‘mil

Short Term Debt 6,659,000 6.15% Short Term Debt 6,554,000 6.97%

Long Term Debt 8,021,000 7.40% Long Term Debt 14,305,000 15.20%

Equity 93,654,000 86.45% Equity 73,236,000 77.83%

Total 108,335,000 100.00% Total 94,095,000 100.00%

Facebook, on the other hand, has been experiencing a decreasing debt-equity ratio since 2008. This is a result of the increasing equity and of the increasing share price, but not of a decrease in debt as predicted by theories that depict a negative relationship between debt uses and growth. Facebook is a growth firm, particularly when it has recently acquired What‘s App from Google, but its growth does not preclude it from using a higher level of debt, which is a phenomenon in contradict with the growth theory aforementioned. Debt level of Facebook has been increasing, but its debt-equity ratio has been declining as a result of a tremendous increase in equity issue [from USD 147 (in billions) in 2008 to USD 10,094 (in billions) in 2012, a 68 times increase in equity]. The increases in equity lead to a decrease in debt-equity ratio despite of the increasing use of debt [total liabilities increased from USD 170 (in billions) in 2008 to USD 3,348 (in billions) in 2012, a 19 times increase in debt], and thus this is an example of a growth firm using more debt but with a low debt-equity ratio. (see Appendix for more on this topic).

Based on this analysis on capital structure, we suggest that Tencent [the company] may have the discretion to use more debt as the company is expanding in size. Competitors such as Yahoo and Facebook are able to maintain a low debt-equity ratio while keep increasing their debt issues merely because they have both their debt and equity increasing jointly year-on-year, with the rate of increase in equity much faster than that in debt, and thereby create a false sense of a decrease in debt uses.

Theories suggest higher debt uses to maximize firm value, while competitors’ capital structure suggest otherwise14, we thus rely on the third factor, Asset types, in the part that follows [2.4]. We also consider long term capital structure and target D/E ratio in subsection ii) and other information related to dividend payout in subsection iii).

14 It seems that Tencent’s competitors are using a mix of both debt and equity in raising the money for their capital needs.

15 City University of Hong Kong EF 4313 Corporate Finance

2.4 Asset Types and Other Factors i) Asset Types

Titman and Wessels (1988) includes asset types as one of the determinants to optimal capital structure. Firms with larger portion of non-current assets are likely to incur more debt as a result of having the benefits of lower interest costs obtained from the act of pledging as collateral non-current assets used as a form of repayment upon default on the part of the debt-issuer. Besides, mangers have better than outsiders information about the firm, and thus debts secured by the collateral value of assets will lower the costs through providing assurance to debt-holders.

Table 2.4 shows that Tencent possesses a large portion of fixed assets and long-term deposit that jointly account for over 24% of its total assets. In contrast, its competitors have a much smaller portion of assets composed by non-currents and deposits. Facebook has only 15.8% in property and equipment and Yahoo has less than 20% in its fixed assets together with long term securities (Ratio for competitors will be much lower if we strictly follow the definition of ‘pledged assets’ and exclude from calculation some of the long-term securities that cannot be served as collaterals. Further, we have excluded from Tencent a large portion of fixed assets that can be traded on market but may be deemed as non-pledgable.). Thus, Tencent is able to incur debt at a low cost which encourages higher debt uses because it is an asset intensive company with considerable amount of long-term deposit.

Table 2.4 Non-current Assets Components, Tencent and Competitors Company Fixed Assets Long Term Deposit Long Term Securities Total Assets Ratio Tencent 7,402,766 10,891,718 n/a 75,255,811 24.31% Facebook 2,391,000 n/a n/a 15,133,000 15.80% Yahoo 1,685,845 n/a 1,838,425 17,103,253 20.61%

Apart from the capital intensive reason, we offer numerous explanations to justify the company’s high debt uses. For one, we use Du Pont Identity to explain how the company is benefited from leverage. Du Pont divides ROE into three components: i) Profit Margin, ii) Asset Turnover, and iii) Equity Multiplier. First, increase in leverage induces interest expenses which provides interest tax shield to the firm by lowering taxable profits and thus lowering the tax paid to authorities. Previous part of this paper argues that utilization of debt uses helps the firm to grasp all possible investment opportunities and thus increase revenue. If this holds, profit will increase as a result of both a reduction in tax expense together with an increase in future income. Profit margin will thereby be improved. Furthermore, the asset turnover, which measures the rate of utilization of non-current assets, will rise as a result of increased profit. Lastly, the equity multiplier, as metrics of money invested in non-current assets for each monetary unit of equity capital, may increase if the balance is tilt over debt instead of equity. Return on Equity, which is a composite of these three elements, will increase as a result. If this happens, stock price of the company will rise even further given the increase in ROE15, and thereby enabling Tencent to incur even more debt to minimize its cost of capital and to maximize its firm value.

15 Stock price movements are shown in the diagrams of part 1.1 subsection iii).

16 City University of Hong Kong EF 4313 Corporate Finance ii) Additional Notes on Capital structure

In addition to asset types analysis in determining the source of fund, we examine the capital structure changes of Tencent to ensure that the company’s capability in using additional debt is not impeded by recent events [part 1.1]. Capital structure comparison between Tencent and its competitors’ is illustrated in previous part [2.3]. a) Long-Term Capital Structure of the Company

While the company has recently increased its debt uses due to several reasons earlier mentioned, its past capital structure followed a highly predictable pattern and the debt use has increased gradually to around 50% of total assets, as shown in the diagram for the 10-year change [Appendix 3.3].

In early years, Tencent had kept a steady debt ratio of 10%~20% and had maintained a stable incremental use of debt before the year 2008. In recent years, however, the debt ratio surged to 40%~50% with a sudden increase in 2008 and 2009 which had drastically changed the capital structure.

Table below is the extract of Tencnet’s annual report which may explain the dramatic changes. A huge revenue growth is observed from 2007 to 2008, with value-added services tolled up to $4,914 million which amounted to over 68% of total revenue. In addition, percentage increase in online advertising revenue was up to almost 100%, and the aggregate of the two effects resulted in a 87.25% revenue growth in that year. Since then, Tencent had started to accumulate its long term deposit and began its aggressive financial policies.

Table 2.5 Financial Performance by Segment, Tencent (2009)

Despite the apparently aggressive financial policies, Tencent has successfully maintained high liquidity during its expansion period. Operating cash flows generated are increasing due to revenue enhancement. The repayment schedule is carefully planned to ensure matching of cash inflows with outflows. Besides, the term structure of debts of the company shows that most of the long-term debts are due in more than 5 years after the reporting period. 92% of the long-term debts are beyond three years and only around 3% is due in one year. This indicates that the company’s liquidity and ability to repay interests and principals is likely not going to be impeded by the large amount of debt borrowed nor by the investment projects that it has recently embarked on, mostly because of the sufficiently wide spread-over of repayment schedule that gives the company enough room to prepare for repayment (see Appendix A5 for long-term debt schedule).

17 City University of Hong Kong EF 4313 Corporate Finance b) Short-Term capital structure of the Company

In the following we revisit the current capital structure of Tencent and identify the reason why the company had significant changes in recent years for its debt-equity components. While the past capital structure shows a relatively low use of debt, the current D/E ratio reveals that debt uses have surged to nearly 50% in recent years. However, we see this as evidence of a promising future instead of a burden, as expressed through investors’ confidence to the company shown as below.

Table 2.6 Current Capital Structure of Tencent Tencent 2012 2013 Short Term Debt 20,664,996 27.46% 33,267,000 31.17% Long Term Debt 12,442,549 16.53% 15,505,000 14.53% Equity 42,148,266 56.01% 57,945,000 54.30% Total 75,255,811 100.00% 106,717,000 100.00%

Table 2.6 shows that in recent years about 40%~50% of Tencent‘s total assets was financed by leverage, among which one-third is based on long term debt. The following news explained the reason for higher debt use.

Additional Notes to Debt issues: ‘…Tencent completed a USD600 million senior unsecured notes offering in September 2012. This is its second international bond issue. The first tranche was in December 2011. It reflected investors’ confidence in its business model and financial performance. This changed the capital structure of the company and thus …’ - Annual Report 2012 [Tencent Corporate] Debt uses indicates that investors of the company are generally confident in the business model and financial performance which are exemplified in recent project investments [part 1.1] and in the increasing revenue and net income over the past decade [Table 2.5]. Besides, the level of short-term debts in part determines the length of operating cycle and cash cycle. A firm that is able to incur higher short-term debts normally recoups its money in the operation more efficiently than firms that are having low bargaining power over the suppliers and thus have low amount of short-term debts. We thus argue that the significant level of short-term payables may not be indicative to inefficient credit management; in fact, we suggest otherwise and argue that the high level of short-term debts is a sign of high bargaining power over the suppliers and therefore implies an outstanding supply-chain management which enable the company to shorten both its operating cycle and cash cycle in order to foster business growth and further expansion.

In theory, use of debt is a signal sent out to investors that the firm is able to afford the extra interest costs related to debt increases. While in the short run there may be firms trying to use debt as a signal for good performance (Ross, 1977), in the long run only firms with high net income and robust cash balance can remain high debt uses. We thus suggest a higher leverage to consolidate investors’ confidence and to strengthen the signal sent to the market as a result of its amble capacity in additional debt uses and of investors’ expectation and trust on its incredible financial performance and economically sound business model.

18 City University of Hong Kong EF 4313 Corporate Finance iii) Additional Notes to Dividend payout

In theory it does not matter whether a firm pays now or in future; nor does it matter whether a firm pays out cash or repurchases shares as a form of distribution.16 In reality, however, we observe that most of the time a firm’s stock price changed following the announcement of dividend or repurchase. Hence, we examine the payout policy of Tencent [the company] so as to shed light on and to provide insights for our suggestion in the next part [2.5].

Table 2.7 Dividend policy (Tencent and competitors), 2009 to 2012 Company Payout Policy 2009 2010 2011 2012 Tencent Dividend per share (in RMB) 0.35 0.47 0.61 0.8 Stock repurchase (in thousands) 1,922 2,624 7,585 154,400 Yahoo Dividend per share 0 0 0 0 Stock repurchase (in thousands) n/a n/a n/a 79,585 Facebook Dividend per share 0 0 0 0 Stock repurchase (in thousands) 1,344 0 27,476 4,848

The above table shows that Tencent [the company] has an increasing dividend payout since year 2009, from a per share dividend of HKD 0.35 to HKD 0.8 in 2012, and an announced dividend of HKD 1.00 at the time of writing. In contrast, competitors have never announced a dividend and in their annual report it is clearly stated that they do not have the intent to pay dividend in future. This affirms with the finding that while the number of firms paying dividends is declining, the aggregate amount of payout increases (DeAngelo et al., 2009).

Share repurchase of the company amounted to 154,400 units of common stock in 2012 for an aggregate of HKD 25 million as a form of cash distribution to equity-holders. Same as dividend payout, the stock repurchase of the company has been rising since 2009, whereas competitors have little or none buy-backs for the last few years.

These factors show that the company is eager in maximizing shareholders’ wealth by repaying the profit earned to the contributors. Theoretically, a firm’s value should be positively correlated with its dividend payout and stock repurchases, and a firm that has its dividend increasing from year to year since 2009, together with a repurchase of shares as a reward to equity holders should consequently have its price increased as a result of positive signals sent to investors through the distribution policies (Miller, 1985). Therefore, we observe that the company’s stock price has been increasing from less than HKD 100 in 2009 to more than HKD 600 in 201417 (for stock price and historical performance, refer to section iii) of part 1.1). Thus, we argue that the company is capable to using more debt as a result of increasing equity prices.

16 It is uncommon to see firms paying cash dividends, much attributable to the changing characteristic of firms and the declining propensity to pay. Moreover, literatures seem to oppose the distribution of cash dividends. The classical theory of Modigliani Miller (1961) shows that dividend is irrelevant to firm value and that there is no difference whether or not the firm pays dividend. Bhattacharya (1979) shows further that the ‘bird-in-hand’ assumption is fallible, so the argument that investors prefer cash now to higher stock price as a result of repurchase in future cannot hold. 17 At the time of writing, the stock price of Tencent has declined by a little, much due to the volatility in the internet service provider industry and to investors’ expectation on interest rate movements.

19 City University of Hong Kong EF 4313 Corporate Finance

2.5 Suggestion

From the preceding part we have compared the capital structure of Tencent with its competitors’, their asset types, and their payout policies, which led us to identifying the difference in regards to their capital uses and provided us insights on the priority of capital raising. In the following we in an attempt to suggest capital structure changes (D/E Ratio) in order for the company to efficiently operate in the four projects previously identified and to react promptly to changes in the business environment. In addition, we suggest that Tencent may not need to follow the capital structure of its competitors and may not need not to have a target debt-equity ratio as explained in the tradeoff-off theory based on several reasons:

i) Dividend payout and fixed capital structure Dividend Payout is important to growth firms, but investors prefer capital gain to dividend income because taxes are paid for dividend received.18 If a firm does not pay out dividend, it has relatively low intent to maintain a fixed debt-equity ratio which is maintained by cash-rich firms paying stable streams of dividend.19 Although it may not be a good explanation that a firm having constant dividend must have its debt-equity ratio fixed at all time and that a firm that doesn’t have such constant dividend does not need to fixate its debt-equity ratio, it is usual for a firm that has little intention to maintain a constant flow of dividend to have a fixed debt-equity ratio.

ii) Flexibility of company and fixed capital structure A fixed capital structure is not desirable for a firm that faces dynamics in business environment with the needs to invent and develop new products in that such doing may impede the flexibility of the firm responding to these environment changes. Tencent is a company that is situated in a highly volatile business that requires intensive product research and development. These costs related to development may or may not be estimated precisely, and thus a fixed debt-equity ratio will to some extent undermine the ability of the firm to have flexible allocation of its resources.

iii) Firm’s beta and fixed capital structure A fixed capital structure may in theory helps stabilize the beta of the firm, but in reality beta may not be determined solely by the firm’s capital structure

B 푟 = 푟 + ∗ (1 − 푡 ) ∗ (푟 − 푟 ) 2.1 푠 0 S 푐 0 푑

푟푠 = 푟푓 + β ∗ (푟푚 − 푟푓) 2.2

B 푟 + ∗ (1 − 푡 ) ∗ (푟 − 푟 ) = 푟 + β ∗ (푟 − 푟 ) 2.3 0 S 푐 0 푑 푓 푚 푓

18 Fischer Black (1976) mentioned in his article that investors are subject to personal tax for dividend received but not to capital gain tax until the profit from stock price appreciation is realized. 19 There may be exceptions to this explanation and may have firms that are not paying constant dividend to have maintaining a fixed debt-equity ratio; or, there may have firms that are paying dividend do not have a fixed debt-equity ratio. One thing that is certain is that whenever a firm decides to pay a constant flow of dividend (Lintner, 1956), it needs to maintain a fixed debt-equity ratio in order to lower the interest rate risk and thereby reduces fluctuations in cash flows associated with interest payments so as to have sufficient cash to provide a certain amount of dividend in each period.

20 City University of Hong Kong EF 4313 Corporate Finance

The above are the theories which suggest the cost of equity depends on the capital structure of the firm; the higher the debt the higher the cost of equity as a result of the increasing financial distress costs. If the exogenous factors remain constant and r0, Tc, rd, Rm, and Rf do not change, then the beta of a company can be determined through identifying the optimal debt-equity ratio of that company [Equation 2.3]. From this we are tempted to conclude that the company [Tencent] can lower its beta by setting a low target D/E ratio and thereby using less debt capital. In reality, however, risks can be divided into systematic and unsystematic; some of the risk is not captured by the use of beta and may not be represented in the above equations.

Ra푡 = E(Ra푡) + 휀 푡 = 0,1,2, … , 푇

This suggests that the risk of company20 can be divided into two parts: E(Ra) and 휀. The rate of return on a company at one particular time point depends on the expected value of the return plus the error of the variable. The error part is unsystematic and will be balanced out on average, whereas the expected value part is fixed in the population [E(Ra) is obtained theoretically by exhausting all possible observations in the population and take the average of them. This is to say we include in our sample all Ra’s (past, present, and future) and take their average to be the expected value of the rate of return21] and thus not be changed merely via diversification. In other words, the risk of the company is more or less inherent in its business model and depends more on the projects that it invested in, but less on omitted variable factors or residuals (휀) such as the decision on using debt or equity.

Although the risk of a company depends partially on its capital structure and the use of debt may increase the risk of the company, debt uses is not the sole factor in determining risk [using beta as a form of measurement] and the risk of a company may depend more on the industry that it is operating in and on the projects that it is undertaking than on the source of fund [use of debt or equity as capital]. We thus suggest that Tencent should not be precluded from using debt even if it seeks to lower its risk [beta].

We therefore suggest Tencent to maintain its original debt-equity ratio but still have discretion on extra debt using. Optimal capital structure is estimated at around half of the total capital based on the past performance and historical data related to the company. Yet still, we suggest an increase in debt issue to increase the amount the cash flows available to the company so as to enable a prompt reaction to profitable projects that will increase the net income in future. To maintain the original D/E ratio while increasing the use of debt may require extra equity issue that will lower the earnings per share and thereby lower the share price of the company. But this will be a temporary effect on stock price and will not be a problem if investors later realize that the company has more projects on going that will increase future profits.

20 The word “risk” is used here in its board meaning. Risk in the stock price of a company refers to the variance [or standard deviation] in the stock price at different points in time [risk = {Var(S)}^.5, high variance implies high volatility and thus indicates a high risk]. In theory risk can be divided into systematic and unsystematic, and only systematic risk is rewarded because the market will not pay for bearing unnecessary risks that can be mitigated through diversification. 21 Another approach in calculating expected value of rate of return is to have a probability matrix that has discrete states of high, normal, and low. If it is modeled as a probability of state at time t conditional on the occurrence of states at time t-1, it will be a 3x3 matrix on which the probability of each state occurring is based for the calculation of expected value. The final step is to integrate all the probability of each state and assign that probability to the payoff as a result of a particular state occurring for the calculation of expected value of rate of return.

21 City University of Hong Kong EF 4313 Corporate Finance

Reference

Bhattacharya, S.(1979). Imperfect Information, Dividend Policy and the Bird in the Hand Fallacy. Bell Journal of Economics, Vol. 10, Issue 1, page 259-270.

Black, F. (1976). The Dividend Puzzle, Journal of Portfolio Management, Vol.2, page 5-8

Cantor, David G;Lippman, Steven A.(1983)Investment Selection with Imperfect Capital Markets, Econometrica, Vol. 51, Issue 4, page 1121

Clayman, Michelle R.; Fridson, Martin S.; George H.(2012). Corporate finance: a practical approach, Hoboken, John Wiley & Son

DeAngelo Harry, Linda DeAngelo, and Douglas Skinner (2009). Corporate Payout Policy. Foundations and Trends in Finance, Vol. 3, page 2-3, 95-287.

Fonseka, M M;Ramos, Constantino García;Tian, Gao-liang.(2012) The Most Appropriate Sustainable Growth Rate Model for Managers And Researchers, Journal of Applied Business Research; Vol. 28, page 481

Graham, John R., Scott B. Smart. (2012). Introduction to Corporate Finance, Australia, South-Western Cengage Learning

Lintner J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained Earnings and Taxes. American Economics Review, Vol. 46, page 97 -113.

Miller, M., and Modigliani, F.(1961). Dividend Policy, Growth and the Valuation of Shares. The Journal of Business, Vol. 34, page 411-433.

Miller M., and Rock K. (1985). Dividend Policy under Asymmetric Information. Journal of Finance, Vol. 40, page 1031-1051.

Modigliani, F. and Miller, M. H.(1958). The Cost of Capital, Corporate Finance and the Theory of Investment. American Economic Review, Vol. 48, 261-97.

Murray, Dennis. (2010), What are the Essential Features of a Liability?, Accounting Horizons, Vol. 24, Issue 4, page 623- 633

Myers, Stewart C. (1984), The Capital Structure Puzzle, The Journal of Finance, Vol.39 Issue 3, page 574 – 592

Osawa, Juro. (2014). How Messaging Apps Make Money, Wall Street Journal, retrieved on 25 March 2014 http://blogs.wsj.com/digits/2014/03/03/how-messaging-apps-make-money/?KEYWORDS=wechat

Ovide, Shira. (2014). Moving Beyond the ‘Net Neutrality’ Debate, Wall Street Journal, retrieved on 10 March 2014. http://blogs.wsj.com/digits/2014/01/14/some-in-tech-industry-moving-beyond-net-neutrality-debat e/?KEYWORDS=internet+information+provider

Ross, Stephen A; Westerfield, Randolph W.; Jaffe, Jeffrey.(2013). Corporate finance, New York, McGraw Hill

Ross Stephen A. (1977). The Determination of Financial Structure: The Incentive-Signalling Approach The Bell Journal of Economics, Vol. 8, Issue 1, page 23-40.

Tencent Holdings, http://www.tencent.com/en-us/, retrieved on 20 March 2014

Titman, Sheridan. Wessels, Roberto.(1988). The Determinants of Capital Structure Choice, The Journal of Finance, Vol. 43, Issue 1, page 1-19

Tobin, James. (1969). A General Equilibrium Approach To Monetary Theory, Journal of Money, Credit, and Banking, Vol. 1, page. 15-29

Ulrich, Thomas A;Arlow, Peter (1980). The financial implications of growth, Journal of Small Business Management, Vol. 18, page 28

22 City University of Hong Kong EF 4313 Corporate Finance

Appendix

A1 Explanation on the investment opportunities and growth

We assume here that investment is positively correlated to the needs of funding, as a firm that is going to invest in a positive NPV project must use either debt or equity to finance its projects.

(in lecture 5 there are theories showing that growth opportunities are negatively related to the use of debt, due to the fact that the discounting factor, being the rate of interest minus the growth rate of firm, is reduced for a firm with growth as compared with a firm with no growth. The firm that has no growth has a lower firm value because the net cash flow is discounted on a higher rate while the firm with growth has higher firm value as it is having its cash flows discounted on a lower rate; the low debt to equity ratio in high growth firm is due to the higher value of equity, it may not be that the firm with high growth must use less debt, thus it may be that the two theories are not in oppose to one another) [Lecture 5 ppt, slides 40-42]

A2 Capital Structure Comparison

Yahoo 2012 Facebook 2012 Tencent 2012

Short Short Short Term Debt Term Debt Term Debt

Long Term Long Term Long Term Debt Debt Debt

Equity Equity Equity

2013

Short Short Short Term Debt Term Debt Term Debt Long Term Long Term Long Term Debt Debt Debt Equity Equity Equity

[Data is collected manually by one of the group members from the financial reports of companies, efforts are acknowledged with thanks. Interested readers can have the data via sending a mail to sh12cityu@gmail.com]

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A3 Financial Statements and Capital Structure

A3.1 CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION As at 31 December

Tencent 2008 2009 2010 2011 2012 Assets RMB’000 RMB’000 RMB’000 RMB’000 RMB’000

Non-current assets 3,359,696 4,348,823 10,456,373 21,300,877 38,746,663 Current assets 6,495,861 13,156,942 25,373,741 35,503,488 36,509,148 Total assets 9,855,557 17,505,765 35,830,114 56,804,365 75,255,811 Equity and liabilities Equity attributable to the equity holders 7,020,926 12,178,507 21,756,946 28,463,834 41,297,507 Non-controlling interests 98,406 120,146 83,912 624,510 850,759 Total equity 7,119,332 12,298,653 21,840,858 29,088,344 42,148,266 Non-current liabilities 644,628 644,033 967,211 6,532,673 12,442,549 Current liabilities 2,091,597 4,563,079 13,022,045 21,183,348 20,664,996 Total liabilities 2,736,225 5,207,112 13,989,256 27,716,021 33,107,545 Total equity and liabilities 9,855,557 17,505,765 35,830,114 56,804,365 75,255,811

Facebook (in thousands) 2008 2009 2010 2011 2012 Cash, cash equivalents, 297,000 633,000 1,785,000 3,908,000 9,626,000 Working capital . 279,000 703,000 1,857,000 3,705,000 10,215,000 Property and equipment, 131,000 148,000 574,000 1,475,000 2,391,000 Total assets . 505,000 1,109,000 2,990,000 6,331,000 15,103,000 Capital lease obligations 56,000 95,000 223,000 677,000 856,000 Long-term debt . 0 0 0 250,000 1,500,000 Total liabilities . 170,000 241,000 828,000 1,432,000 3,348,000 Additional paid-in capital 147,000 253,000 947,000 2,684,000 10,094,000 Total stockholders’ equity 335,000 868,000 2,162,000 4,899,000 11,755,000

Yahoo (in thousands) 2,008 2,009 2,010 2,011 2,012 Cash and cash 2,292,296 1,275,430 1,526,427 1,562,390 2,667,778 Marketable debt securities 1,229,677 3,242,574 2,102,255 967,527 3,354,600 Alibaba Group Preference 816,261 N/A N/A N/A N/A 2008 2009 2010 2011 2012 Working capital . 3,040,483 2,877,044 2,719,676 2,245,175 4,362,481 Investments in equity 3,177,445 3,496,288 4,011,889 4,749,044 2,840,157

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Yahoo (in thousands) [cont’] 2008 2009 2010 2011 2012 Total assets . 13,689,848 14,936,030 14,928,104 14,782,786 17,103,253 Long-term liabilities . 715,872 699,666 705,822 994,078 1,207,418 Total Yahoo! Inc. 11,250,942 12,493,320 12,558,129 12,541,067 14,560,200

A3.2 Debt-equity Ratio of the three companies, 2008 to 2012 D/E Ratio 2008 2009 2010 2011 2012 Tencent 38.43% 42.34% 64.05% 95.28% 78.55% Facebook 50.75% 27.76% 38.30% 29.29% 28.48% Yahoo 6.36% 5.60% 5.62% 7.93% 8.29%

Exhibit A3.1 Debt-Equity Ratio of Tencent, Facebook, and Yahoo 120.00% 100.00% D/E Ratio 80.00% Tencent 60.00% 40.00% Facebook 20.00%

0.00% Yahoo 2008 2009 2010 2011 2012

A3.3 Capital Structure Changes, 2003 to 2013

Exhibit A3.2 10-year (2013 excluded) capital change, Tencent One Decade Capital Structure Change

100.00%

80.00%

60.00%

40.00%

20.00%

0.00% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Equity ratio 81.98% 92.63% 85.53% 79.94% 75.59% 72.24% 70.25% 60.96% 51.21% 56.01% 54.30% Debt ratio 18.02% 7.37% 14.47% 20.06% 24.41% 27.76% 29.75% 39.04% 48.79% 43.99% 45.70% Debt ratio Equity ratio

25 City University of Hong Kong EF 4313 Corporate Finance

A4 Internal Growth Rate and External Financing Needs

Tencent 2012

Assets 75,255,811

Sales 43,893,711

Sales_Previous 28,496,072 Delta_Sales 54.03% Spon_Liability 4,211,733 Profit_Margin 29.13% Net Income 12,784,852 Predicted_Sales 67,609,483 Dividend_Payout 14.30% Dividend 1,827,886

EFN 92,552,179

this assumes that the assets and liabilities change at the same rate as the change in sales

A5 Long-term Debt Schedule of Tencent 2012

Tencent 2012 RMB (in Millions) Percentage of Total LT Debt (Incl. Cap. Leases) Due in one year 347.9 3.3%

LT Debt (Incl. Cap. Leases) Due in two years 442.2 4.1% LT Debt (Incl. Cap. Leases) Due in three years 1,900.7 17.8% LT Debt (Incl. Cap. Leases) Due in four years 1,900.7 17.8% LT Debt (Incl. Cap. Leases) Due in five years 1,900.7 17.8% LT Debt (Incl. Cap. Leases) Due, Next 5 Yrs 6,492.4 60.7% LT Debt (Incl. Cap. Leases) Due, After 5 Yrs 3,224.3 30.1%

Source: Annual Report 2012, Tencent Holdings

26 City University of Hong Kong EF 4313 Corporate Finance

Afterword

This paper has undergone substantial changes from its first draft, but in essence it retained the most significant part that is relevant to capital structure. From planning, drafting, writing, and editing, it spent the author almost one whole semester to gather enough material and to revise all concepts related to topics on corporate finance. The final output is a perfect matching of qualitative and quantitative approaches to capital structure analysis. Equations are kept in its simplest form and materials on econometrics are removed so as to keep best readability.

Furthermore, past literatures on capital structure were reviewed and accounting journals are cross-referenced when there was dispute over the definition of debt and liability. Literatures tend to include various determinants to identify the optimal capital structure so as to minimize the cost of capital. In this paper, however, we argued that a company should focus on capital needs rather than on the optimal structure which was claimed by most to have effects on maximizing firm value. We argued further that a company should on its discretion increase or decrease its leverage, irrespective of the order theories suggested. It is in our opinion that theories should serve as guidance and seldom as prescription. Hence, the company chosen for this paper was advised to examine situations and circumstances surrounding and decide on the best solution on a case-by-case basis.

The whole purpose of this paper is to gather insights from classical theories and to leave a framework under which readers can decide the methods to financing when there is a capital need as a result of business expansion.

Thus far it comes to the end of semester and the end of years spent at City University. I first planned to write this paper using concepts learnt in other disciplines and apply econometric on the calculation of beta and D/E ratio. Later I learnt that only works that fit the market demand (readers’ expectation) are well received, so concepts out of this course are excluded, and the OLS that I planned to include in this paper has to be replaced with abundant facts of the company chosen for the purpose of capital structure analysis. Yet, every line of this work was finely edited and I aim to put this term paper as one of the best works in my years at this university.

Another two pieces of assignments [Massy Ferguson and Eskimo Pie] together with all the long questions in the three Problem Sets, when accompanied with this term paper, composed a fine picture of all related concepts in corporate and accounting intriguing to me as a person seeking knowledge throughout these years.

The intellectual activity from this course is rewarding. In particular, writing an xlsm to demonstrate the three approaches to valuation with the sensitivity of interest expense to NPV is certainly aspiring. Review on literature is both intriguing and mesmerizing in that classical journal articles were finely crafted, and there are linkages in most of the papers written by different authors (such as the two puzzles quoted in this paper as reference). The process of reading through piece by piece is fruitful and rewarding.