Do Indonesian firms practice target capital structure? A dynamic approach

Pages318-334
Published date01 August 2016
DOIhttps://doi.org/10.1108/JABS-07-2015-0100
Date01 August 2016
AuthorRazali Haron
Subject MatterStrategy,International business
Do Indonesian firms practice target
capital structure? A dynamic approach
Razali Haron
Razali Haron is based at
IIUM Institute of Islamic
Banking and Finance,
International Islamic
University, Kuala Lumpur,
Malaysia, and Centre for
Islamic Economics,
International Islamic
University, Kuala Lumpur,
Malaysia.
Abstract
Purpose This study aims to investigate the dynamic aspects in the capital structure decisions of firms
in Indonesia, offering an extension to the existing literature on Indonesia via a dynamic model, including
the existence of target capital structure, the influencing factors, the speed of adjustments and the
supporting theories to explain the findings.
Design/methodology/approach This study uses a dynamic partial adjustment model estimated
based on a generalized method of moments.
Findings Indonesian firms do practice target capital structure and are influenced by firm-specific
factors like profitability, business risk, firm size, liquidity and share price performance due to
time-varying factors. A rapid adjustment toward target leverage is detected, thus supporting the
existence of the dynamic trade-off theory (TOT). The pecking order theory (POT) also has significant
influence, particularly after the new reformation of financing policy, where retained earnings are also
preferred as a source of financing apart from merely external financing through bank loans. There are
also traces of market timing influences where firms also seem to time their equity issuance.
Research limitations/implications Despite relatively utilizing recent data and bigger sample firms
compared to the previous limited studies on Indonesia, the results of this study, however, need to be
cautiously interpreted. First, the sample chosen focused on listed firms, hence may not be generalized
to all Indonesian firms, listed and unlisted. Second, the study does not separate firms by sectors and
their leverage positions, that is under-levered and over-levered, so as to note that financial decisions
may also be affected by the sector in which the firms operate and their leverage positions. These are to
be considered in future research.
Practical implications There is strong evidence that the corporate financing behavior of Indonesian
firms is governed by the POT and TOT. Both are dealing with the function of debt. The financial sector
reformation does have a positive impact on the banking sector, but not the local corporate bond market.
Therefore, regulators and policymakers should bear in mind that banking as well as private bond market
in Indonesia must be tailored in such a way that both could act as intermediaries of debt financing, as
bond market represents an important component of a diversified financial sector.
Originality/value This study fills the gap by providing an extension to the existing literature and a
deeper insight of the capital structure of Indonesian firms using a more robust dynamic model.
Keywords Emerging markets, Speed, Capital structure
Paper type Research paper
1. Introduction
Despite being extensively examined and investigated, capital structure and its impact on
firm value still capture the interest of many researchers throughout the decades. Instigated
by Modigliani and Miller in 1958, the capital structure puzzle is, apparently, still unresolved
(Al-Najjar and Hussainey, 2011). Survey evidence indicates that some firms have a target
debt ratio and some firms issue certain level of debt or equity (Graham and Harvey, 2001;
Baker and Powell, 2012). Nonetheless, no universal consensus on the perfect debt and
equity ratio has been reached so far for a firm to use in their capital structure (Haron,
2014a). Related studies have been testing and examining the influence of four dominant
theories in capital structure studies in pursuing the target, which are the trade-off theory
Received 15 July 2015
Revised 28 September 2015
27 December 2015
Accepted 14 January 2016
PAGE 318 JOURNAL OF ASIA BUSINESS STUDIES VOL. 10 NO. 3, 2016, pp. 318-334, © Emerald Group Publishing Limited, ISSN 1558-7894 DOI 10.1108/JABS-07-2015-0100
(TOT), the pecking order theory (POT), the agency theory and the market timing theory. The
TOT argues that optimal leverage is achievable when the cost of debt is traded-off with the
benefits of debt. The balances of the costs and benefits of debt determine the optimal
leverage ratio. Examples of leverage-related costs taken into account in some empirical
corporate financing investigations are bankruptcy costs (Scott, 1977), agency costs
(Jensen and Meckling, 1976) and the loss of non-debt tax shield (DeAngelo and Masulis,
1980).
Derived from asymmetric information problems, the POT, on the contrary, asserts that there
is no optimal capital structure, instead a firm will practice financial hierarchy. When the
manager is likely to have a great deal of private information regarding the value of the firm
than outside investors or even the creditors, the financing method chosen by the manager
can serve as a signal. Thus, the information asymmetry which occurs between the two
parties drives the manager to practice hierarchical financing where internal financing will
be the first choice, followed by debt, and equity is issued only when firms have no more
debt capacity (Myers and Majluf, 1984).
The agency theory is based on another problem due to information asymmetry, that is
the agency problem. Unlike the POT, the agency theory argues that optimal capital
structure can be achieved when the costs arising from conflicts between the parties
involved are minimized. Jensen and Meckling (1976) argue that the use of debt
financing can ease the conflicts or the moral hazards that may exist between
shareholders and debt holders for debts can discipline managers. When the agency
costs, which include the monitoring expenditure by the principal, the bonding
expenditure by the agent and the residual loss, are balanced-off against the benefits of
debt, the optimal capital structure can be achieved. Baker and Wurgler (2002),onthe
other hand, suggest that in the market timing theory, the capital structure has always
been impacted by market valuation. This theory states that the current capital structure
is based on the firm’s historical experiences of being overpriced or underpriced by the
investors. A firm with a history of strong stock price will issue more equities and less
debt, whereas a less fortunate firm will suffer from high debt ratios.
Massive effort has been carried out attempting to examine these theories at work in
different economic settings. Titman and Wessels (1988),Harris and Raviv (1991) and
Al-Najjar and Hussainey (2011) are among those who conducted studies on the developed
markets, while Booth et al. (2001),Ruslim (2009),Setyawan and Budi (2012) and Memon
et al. (2015) on developing or emerging markets. Nevertheless, all these studies share one
common model, which is the static model imposing the implicit, but unrealistic, assumption
that firms are always at their target capital structure. Due to the nature of the static model,
the observed debt ratio is used as proxy for an optimal leverage ratio. Researchers then
realize that firms may not at any time be at their target leverage due to different shocks and
will occasionally rebalance depending on the adjustment cost incurred (De Miguel and
Pindado, 2001;Hovakimian et al., 2001;Drobetz and Wanzenried, 2006). A static model, as
explained by Strebulaev (2007), may not be able to explain the variances between firms in
the cross section due to the differences between actual and target leverage, and that
deviations from target may distort the results of empirical research. Realizing that, a partial
adjustment model of capital structure has then begun to attract considerable attention
(Hovakimian et al., 2001;Leary and Roberts, 2005;Flannery and Rangan, 2006;Strebulaev,
2007;Daher et al., 2015). Empirical evidence has then shown that firms do pursue target
capital structure, get deviated from time to time due to occasional shocks and do readjust
to target depending on the deviation cost incurred (Oztekin and Flannery, 2012;Haron,
2014b).
The emergence of the dynamic model which allows the identification of target leverage, the
estimation of the magnitude of the adjustment speed and the deviation cost has become
the trend in recent literature (Drobetz and Wanzenried, 2006;Aybar-Arias et al., 2011;
Oztekin and Flannery, 2012;Haron et al., 2013a;Haron, 2014a;2014b;Daher et al., 2015).
VOL. 10 NO. 3 2016 JOURNAL OF ASIA BUSINESS STUDIES PAGE 319

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