*3.2. A Framework to Measure the Construct of Overborrowing*

According to the theory of corporate finance, firm's financing choice depends on a tradeoff between different financing alternatives. Without loss of generality, we assume that the firm faces a project with positive net present value, and the financing alternatives comprises two ways, namely, the bank loans and retained earnings. Bank loans represents debt financing, while retained earnings are a proxy of direct financing. If the cost of bank loans is greater than that of retained earnings, the firm tends to adopt retained earnings instead of bank loans. Otherwise, the firm will increase bank loans. When the financing demand is fixed, firm's bank loans would depend on the expected weighted average capital cost (WACC) for the project. Bank loans (BL) thus can be expressed as follows:

$$\text{BL} = \mathcal{F}(\text{WACC})$$

Theoretically, there is an optimal point of borrowing level, at which the weighted average capital cost for the project is the lowest. We mark the ideally optimal borrowing level as F(WACC∗), where WACC<sup>∗</sup> corresponds to the optimal capital structure. When there is overborrowing or underborrowing, the actual bank loans will inevitably deviate from the optimal level, leading the weighted average capital cost away from the optimal point WACC∗. Real bank loans can then be split into two main components:

$$\text{RBL} = \mathcal{F}(\text{WACC}^\*) + \Delta \text{BL}$$

The deviation from the ideal value (ΔBL) can be negative or positive. Negative (positive) values corresponds to under (over)borrowing. The focus of the empirical analysis in this study is on the overborrowing. Hence, the analysis will focus on the firms with positive values. There is an extensive literature in economics and finance that have examined firm level borrowing decisions [36,86,87]. The overborrowing will eventually lead to increment in firm's risk but without extra net cash inflow, and thus impairs the firm's value. It could reflect management engaging in additional investment on self-serving projects rather than distributing the cash to shareholders [25].

From the perspective of equilibrium in credit market, the ideal bank loans (BL) firm demands is always the same as the optimal lending volume bank approves. By examining the bank loans-setting mechanism we can obtain the empirical estimation of overborrowing described in this framework.
