The effect of capital structure on profitability and stock returns. Empirical analysis of firms listed in Kompas 100
| Date | 03 June 2019 |
| Pages | 74-89 |
| Published date | 03 June 2019 |
| DOI | https://doi.org/10.1108/JCEFTS-11-2018-0042 |
| Author | Teddy Chandra,Achmad Tavip Junaedi,Evelyn Wijaya,Suharti Suharti,Irman Mimelientesa,Martha Ng |
| Subject Matter | Economics,International economics |
The effect of capital structure on
profitability and stock returns
Empirical analysis of firms listed in Kompas 100
Teddy Chandra,Achmad Tavip Junaedi,Evelyn Wijaya,
Suharti Suharti,Irman Mimelientesa and Martha Ng
STIE Pelita Indonesia Pekanbaru, Pekanbaru, Indonesia
Abstract
Purpose –The purpose of this study is to examinethe factors that influence capital structure, profitability
and stock returns and the relationship between capital structure, profitability and stock returns. The
endogenous variables in this study are capital structure, profitability and stock returns, whereas the
exogenousvariables are firm size, growth opportunity, tangibility,liquidity, volatility and uniqueness.
Design/methodology/approach –The population used is a company that is listed on the compass
index 100 periodof August 2016. A total of 64 companies are sampledin this study. The unit of analysis is 448
data. The dataanalysis technique used is path analysis with the help of AMOS.
Findings –The results obtainedshow only profitability variables that affect stock returns. Variable capital
structure, firm size, growth opportunity, tangibility and liquidity have no significant effect. Variables that
influence capital structure are only influenced by growth opportunity, whereas other variables are not
significantand variables that affect profitability are firm size, growth opportunity,uniqueness and volatility.
Originality/value –Path analysis is a model similar to the multipleregression analysis, factor analysis,
canonical correlation analysis, discriminant analysis and more general multivariate analysis groups. This
research discussesthat capital structure is useful for increasing the valueof the company in the sense that the
more debt thatis used, a tax deduction will be obtained because of interestcosts. So that the company’sprofits
will increase and eventually will increase the value of the company. This opinion remains a controversy
among financial experts. Until now, there is no agreement that can explain the capital structure in all
conditions of the company. There are two important theories concerning capital structure, trade-off theory
and peckingorder theory.
Keywords Profitability, Stock returns, Pecking order theory, Capital structure, Path analysis,
Trade-off theory
Paper type Research paper
1. Introduction
Indonesia’s foreign debt tends to increase every year. It reached $US202.41bn in 2010 and
$US352.25bn in 2017(Bank Indonesia and Ministry of Finance, 2018). The debt is a
combination of the IndonesianGovernment debt and private debt. Government debt reached
$US 118.62bn in 2010, whereas private debt reached $US83.79bn. In 2017,government debt
reached $US180.62bn, whereas private debt reached $US171.63bn. The debt of private
companies in Indonesia increased dramatically to 104.83 per cent within sevenyears. This
shows that Indonesiancompanies still rely on sources of debt funds.
Since Modigliani and Miller announced the publication of their paper on “irrelevance
theory,”many studies have criticized and researched capital structure. Some say that debt
will affect the capital structure, whereas others say debt has no effect on capital structure.
Dawar, a researcher who researched companies in several sectors on the Bombay Stock
Exchange, found a negative effect of capital structure on profitability. In other words, an
JCEFTS
12,2
74
Journalof Chinese Economic and
ForeignTrade Studies
Vol.12 No. 2, 2019
pp. 74-89
© Emerald Publishing Limited
1754-4408
DOI 10.1108/JCEFTS-11-2018-0042
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1754-4408.htm
increase in debt will result in a decrease in company profits (Dawar, 2014). On the contrary,
Gill et al. (2011) who examined service and manufacturing companies listed on the New
York Stock Exchange found a positive effectof capital structure on profitability. In addition,
Yang et al. (2010) in their researchon companies listed on the Taiwan Stock Exchange found
a negative effect of capital structure on stock returns in 2005. In contrast, for research in
2003 and 2004, they found a positive effect of capital structure on stock returns. In the
research conducted by Ahmad et al. (2013), they found a positive effect of profitability on
stock returns.
This study aims to examine the factors that affect capital structure, profitability and
stock returns, as well as the relationship between capital structure, profitability and stock
returns in firms listed in Kompas100.
2. Literature review
2.1 Financial management
The purpose of the company was established to gain profits, survival and growth of the
company. To achieve the managementobjectives of this company, financial managers need
to make decisions about financialpolicy as follows (Chandra, 2016):
the investment decision;
the financing decision; and
the dividend decision.
By optimizing the three decisions mentioned above, it is expected to increase optimal
company value. This means thatif all three decisions can be taken optimally, then the stock
price and dividends, which are elements in the stock return, will increase. Increasing stock
returns will furtherincrease the prosperity of shareholders.
2.2 Capital structure
The most optimal capitalstructure is a condition where the cost of capital is charged and the
risks faced reach a minimum. If the most optimalcapital structure is obtained, it is expected
to increase the company’s stockprice and then increase the value of the company.
2.3 Net profit approach
This net income approach was developed by David Durand in 1952 (Chandra, 2016). Net
profit meant here is profit that is obtained after deducting all costs, but not deducted from
income tax paid by the company. The emphasis of the net profit approach is on the
relationship betweencost of capital, capital structure and firm value.
2.4 Net operating profit approach
Net operating profit (net operating income) is profit earned after deducting the company’s
operating costs. So, this net operatingprofit does not include other costs and other incomein
the company.
2.5 Traditional approach
In this traditional approach,it is said that the use of debt to a certain extent will not increase
the risk of the company. If you do not experience an increasein risk, the cost of debt (Ki) and
the cost of your own capital (Ke) will be constant. This condition will result in a decrease
in the weighted capital cost (Ko) as experiencedin the net income approach.
Capital
structure on
profitability
75
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