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Motivated by Friedman, Johnson, and Mitton (2003), Wei, Chen and Wirth (2016) consider a situation in which controlling shareholders siphon off firms’ resources before they are used for legitimate operations. Such tunnelling is potentially costly to the controlling shareholders. The most obvious costs are monetary fines from regulatory institutions and reputation penalties from market participants. The other cost of expropriation is losing the return opportunities associated with the tunnelled (and so reduced) operating assets.

This study uses the following variables in the remainder of this paper: T=operational tunnelling level;

W=total wealth of controlling shareholders ߙ=controlling shareholders’ ownership;

A଴=the current value of firm assets without tunnelling and without growth;

g=growth rate; and C=the cost of tunneling.

When controlling shareholders conduct operational tunnelling T, the post-tunnelling firm value is (ܣ଴െ ܶ). The variable ܳ PHDVXUHV WKHadded value of the firm caused by its growth opportunities; and the firm’s net value will be the current value plus the growth value, which is ܣ_଴+ܣ_଴*g. Following Friedman et al. (2003),and Wei, et al. (2016), and with the rationale that the marginal risk of penalties increases as the amount of tunnelling increases, this study assumes the cost of tunnelling to be a quadratic function to the amount of T, ܥ݋ݏݐ= ܥܶଶ, as used by Friedman et al.(2003).

6LQFH FRQWUROOLQJ VKDUHKROGHUV RZQ Į IDFWLRQ RIthe firm, the net wealth for the owner

from the firm is:

ܹ =ߙ(ܣ_଴െ ܶ)(1 +݃) +ܶ െ ܥܶଶ _(4.1)

In this form three effects are considered: 1) The value of tunnelled assets is a direct addition to the owner’s wealth; 2) the owner’s ownership value is reduced by the amount of (Į7J; and 3) the owner will suffer a penalty with increasing marginal cost. The

dominant owners will choose the level of tunnelling, T, to maximise his/her wealth and, therefore the optimisation condition is:

డௐ

డ் = െߙ(1 +݃) + 1െ2ܥܶ= 0 (4.2)

Solving for the first –order condition, this study obtains the optimal tunnelling level:

ܶכ ₌ଵିఈ(ଵା௚)

ଶ஼ (4.3)

The model (equation 4.3), developed by Wei, et al. (2016), predicts that: (i) Firms with higher growth opportunities (expressed as g in equation 4.3) practice less operating tunnelling; (ii) firms with higher ownership concentration (Į in equation 4.3) practice less operational tunnelling; and (iii) firms that face higher penalty costs (C in equation 4.3) practice less operational tunnelling.

This study has described the “princelings” sample firms in the previous chapter, in that they have the characteristi of “Golden hens” instead of “Chickens”. These firms are selected by the “princelings” investors and they are more prosperous in operating business with higher operating profits. The model of equation 4.3 indicates that controlling shareholders who are aiming to maximise their personal wealth are less likely to kill the golden hens that lay golden eggs. With this in mind, it is better to keep the golden hens alive so that they will have more eggs. Based upon the model prediction, the “princelings” type of politically connected firms will engage in less tunnelling in stage 1 of the process. To verify the higher operating performance, this study sets Hypothesis 1, and to test the cash tunnelling behaviour it sets Hypothesis 2

Hypothesis 1: Firms connected to “princelings” outperform unconnected firms in terms of operating performance and growth opportunities.

Hypothesis 1 predicts that firms belonging to families or associates of these influential political elites should outperform other public firms on the Chinese stock market. To test this prediction, this study focuses on both profitability and growth opportunities. Similar tests are reported in Chapter 3 using accounting ratios of Net Profits and Retained Earnings; here we use different and more conventional variables to verify the prediction.

Variables: Profitability: Net cash flow from operating activities deflated by total assets (NOC); and Net income deflated by total assets (ROA).

Growth opportunities: Annual sales growth rate (GROWTH).

Hypothesis 2: Politically connected firms are less likely to conduct tunnelling through operating activities.

Following from the above model (equation 4.3), it is predicted that the “princelings” PCFs are less likely to commit operational tunnelling. This study uses two proxies to indicate the level of operating tunnelling; the ratio of “Other receivables”, and the ratio of “Selling” expenses.

Variables: Operating tunnelling: Other receivables deflated by total assets (OREC); and Selling expenses deflated by total revenues (SEXP).

The practice of making inter-corporate loans is widely used by Chinese listed firms. They are typically reported as an “Other receivables” asset account on the balance sheet (Jiang et al., 2010). “Other receivables” are only disclosed at the year-end and there is no itemising of transactions between controlling shareholders and the corporations during the accounting period. As a result, the vague definition of “Other receivables”, and the minimal disclosure requirements for it make manipulation possible. Until 2006, the CSRC mandated the disclosure of “Other receivables” by listed companies.

Alternatively, an indirect way to examine operational tunnelling is to trace selling expenses as a percentage of total assets (Ma, 2012). This indirect approach is motivated by the Chinese cultural practice that business deals are normally conducted through social/entertainment activities. According to Ma (2012), the most common type of entertainment is to enjoy an expensive meal with associates at a nice restaurant. Additionally, in order to build and maintain political ties, connected firms have a desire to reward their supporters by “gift-giving”. The benefits of “gift-giving” can be either pecuniary or non-pecuniary, such as luxury houses, cars and famous paintings. Such miscellaneous expenditure should ultimately be reflected in the cost of sales. In practice, Chinese firms often use the “Selling expenses” account to cover these expenditures. Therefore, the extra selling costs could be the result of asset transfers by controlling shareholders.

This study has described some special features of our “princelings” PCFs. These firms are described as “Golden hens” and the most beneficial use is to harvest “golden eggs” at some point in the future. In the next step we develop a theory to describe the rational behaviour of controlling owners in distributing the eggs. This study starts from the assumption that the controlling owners will not agree to distribute the eggs in fair proportions. They usually have the power to get higher shares in the post operating income distribution stage, which is described in model 2 in the next section.