Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
Dynamic Capital Structure Adjustment Towards Target Optimal
Capital Structure Evidence from Indonesia
Ridho Bakti* and Subiakto Soekarno**
The research of capital structure found that there are trade-off between the
benefit and cost to achieve optimal capital structure. trade-off theory
implied that there are targeted optimal capital structure and the firm always
adjust to their target capital structure. the purpose of this study is to find the
adjustment speed of the firm towards target capital structure and the
determinant of the dynamic capital structure in context of Indonesian firm
during period 1996-2013 . existing capital structure target adjustment model
applied to panel data and use fixed effect regression technique with total
449 observation. The result of this study shows us 33.5% the gap between
current and desired leverage within one year or equivalent to 2.98 year to
fully reach target leverage. this result show rapid adjustment toward a firmspecific capital ratio suggest the existence of trade-off theory which state
that firm have targeted capital structure and wish to return to those targets
when the cost and benefits is optimal. This result also shows the significant
firm-specific factor toward target leverage are profitability, size, growth
opportunity, non-debt tax shield, and liquidity. This study confirms the
behaviour of dynamic capital structure adjustment support both of trade-off
theory and pecking order theory.
Key words: Dynamic Capital structure, Indonesia, Adjustment Speed, Targets
1. Introduction
The importance of the capital structure choice for the company valuation has been one
of the central questions in academia since first modern capital structure work from
Modigliani and Miller (1958). Since then, numerous academicia elaborate and introducing
new theorem about capital structure by looking in different variable, methods and utilize
various assumptions. Target of capital structure is combine the source of funds used by
company to run the operational in order to minimize the capital cost and maximize stock
price. This capital structure known as optimal capital structure. Main question faced by
financial manager is how they can achieve the optimal capital structure. Several theories
that support capital structure decision to achieve the optimal capital structure such as
trade-off theory, pecking order theory, signaling theory, and market timing theory. Trade
off theory describe firm‟s simultaneous choice of capital structure, investment and
dividend payout under the trade off between tax benefits and financial distress costs,
pecking order theory is concern to the internal fund in order to maximize their firm value,
while market timing theory explain the capital structure of firm will change caused by the
behaviour of the company towards their market value.
______________________________________________________________________
*Ridho Bakti, School of Business and Management, Institut Teknologi Bandung, Indonesia. Email :
ridho.bakti@sbm-itb.ac.id,
** Ir. Subiakto Soekarno, MBA, RFA, School of Business and Management, Institut Teknologi Bandung,
Indonesia. Email : subiakto@sbm-itb.ac.id,
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
The dynamic trade-off capital structure argue that every firm has target leverage, and
there is some adjustment towards optimal capital structure. there are numerous studies
empirically partial-adjustment models such as Fama and French (2002), Flannery and
Rangan (2006), Huang and Ritter (2009) but there is limited studies related to dynamic
capital structure adjusment theory in Indonesia. Encouraged by this research gap, we
make this research to fill the gap by understanding the capital structure adjustment in case
Indonesian companies. We analyze the effect of firm-specific variables to the adjustment
towards targeted leverage.
The remainder of this paper is organized as follows. Next section discuss about
literature review and studies prior to dynamic trade off theory , next we discuss the
methodology, construct the regression model, determine the firm characteristic, the data
and limitation of the research. Then, we provide the result of finding, and the last is
conclusion and recommendation.
2. Literature Review
Theoretically, according to Robert C Higgins (2004) capital structure is the composition of
the liabilities side of a company‟s balance sheet, the mix of funding sources a company
uses to finance its operations. There are numerous study that research the optimal capital
structure as a best of mix from debt to equity. The academician explain capital structure
with different theorem and mode under different assumptions, and propositions. Start by
Modigliani Miller (1958) propose that under strict assumptions of perfect market, firm value
is independent of its capital structure. In Modigliani Miller proposition II without taxes the
cost of equity rises with leverage because the risk of equity rises with the leverage, but
application in the real world, this proposition seems unrealistic, because it is ignore
bankruptcy cost, taxes ignored and ignore another agency cost. Furthermore, MM include
the bankruptcy cost, the higher the debt the higher risk of the firm. This implied that the
firm have optimal capital structure in order to maximize the value.
After Modigliani Miller, several academicia developed capital structure model with different
assumption. There are three major theory in capital structure such as trade-off theory,
pecking order theory, and market timing theory. Static trade off theory indicate optimal
capital structure by trade off the cost and benefits of borrowing, investment plan, tax shield
benefit and other agency cost. According to Myers (1984) a firm that follows trade-off
theory sets a target debt-to-value ratio and then gradually move to the target. This Means
that trade-off theory support that every firm have targeted optimal capital structure. Myers
(1984) argues that adverse selection implies that retained earnings are better than equity.
Firm prefer internal financing rather than external financing. According to Myers (1984) the
summaries of the financing with the pecking order are first internal finance, using dividend
policies, then if external finance is required firm issue the safest security start by debt with
equity as a last resort. While Market timing theory explain that the capital structure of the
firm will change caused by the behaviour of the company that more likely to issue equity
when their market values are high, and repurchase the equity when their market values
are low.
Trade-off theory can be divided by two model : static trade-off theory and dynamic tradeoff theory. While the static trade-off implied that the firm is in their optimal leverage,
dynamic model shows partial adjustment of leverage to the optimal target leverage. For a
decent year, many studies use this dynamic trade-off capital structure to capture the
adjustment toward target leverage (see Fama and French (2002), Flannery and Rangan
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
(2006), Lemmon,Robert and Zender (2008), and Huang and Ritter (2008). In their studies,
they found that the firm has target leverage with adjustment speed estimation is around
17-30%.
3. The Methodology and Model
3.1 Data
Research object for this paper are firm characteristic such as leverage, dividend pay out
ratio, profitability, size of firm, growth opportunity, non debt tax shield, and liquidity.
Population for this research is Indonesian firm that publicly offered and the sample that
author use is limited to the companies that include in LQ 45 index except for financial
based companies for period 1996-2013. Financial companies is excluded from the sample
because their financing decision is different from others. This practice is in line with Rajan
and Zingales (1995). In LQ 45 for period July 2014, there are 5 financial companies, and 2
companies that are IPO in 2012 which means cannot be include to our research because
unable to get the dynamic regression model. We gather all the financial data from
indonesian stock exchange, and indonesian capital market library (ICAMEL). The data
gather by using literature study and documentation method. Literature study means that
we gather theoritical foundation from literature study, journal, article that related to the
topic of this research. Documentation method by collect the documentary data such as
company annual financial report for the sample of this research. By doing so, we were
able to obtain a panel consist of 449 observations.
3.2 Regression model
We use panel data observation which is combination of cross section and time series data
in order to gain more control in heterogenity of the data. To identify the effect of firm
characteristic to the capital structure changes of Indonesian firm, we refer to the model
developed by Flannery and Rangan (2006). According to the Flannery and Rangan (2006)
partial adjustment method will indicate typical adjustment speed of initial capital ratio
toward its target within each time period.
(3.1)
With partial adjustment model, adjustment of its actual leverage to the desired leverage
shown on this formula :
(3.2)
Subtituting formula (3.1) and (3.2) and re-arranging gives an estimable model
(3.3)
λ
= the adjustment speed of firms to their desired capital structure.
= Capital Structure (leverage) firm i and t time
= Capital Structure determinant at t-1 (lag) consist of variable dividend, profitability,
growth opportunity, size of firm, tangibility, non debt tax shield and liquidity
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
Β
= Coefficient of determinant
e i,t
= Random error term
from formula above, we can capture the adjustment speed towards to targeted capital
structure and the capital structure determinants characteristic. Being proxy to capital
structure, it is important to have a clear defintion of term leverage since there are many
definition, and no universally accepted definition for leverage. in this paper, we have
chosen to define corporate leverage as the book value of total liabilities (sum of short,
medium, and long-term debt) divided by the book value of total assets. This in line with
definition from Titman and Wessels (1988), leverage is defined as the ratio of total debt
and long term debt to total asset at book value and ratio of total debt and long term debt to
total asset at market value. We use book value because it gives a better reflection of
management target debt ratio and not affected by market prices.
3.3 Determinants of leverage
In this research we have used the variable like dividend payout ratio, tangibility, size of the
company, profitability, non-debt tax shields, liquidity to determine optimal leverage ratio.
Following are the characteristic and their expected relationship to the leverage:
3.3.1 Profitability
Profitability of the company generally affect the debt to equity ratio. The higher the
profitability of the company, the lesser the company use external financing. It means
profitable company prefers use internal fund for the operational activity rather than
external fund or debt. Profitability have negative relation toward leverage as stated by
Titman and Wessel (1988), Harris and Raviv (1991), Rajan and Zingales (1995), and
Frank and Goyal (2003).
(3.4)
3.3.2 Tangibility
According to Rajan and Zingales (1995) if large fraction of a firms assets is tangible, then
it will serve as collateral, reduce the risk of the lender suffering the agency costs of debt.
The asset should also retain more value in liquidation and it will generate more loan by the
lender and the leverage should be higher. Tangibility has positive relation to leverage as
stated by Rajan and Zingales (1995).
(3.5)
3.3.3 Firm Size
According to Rajan and Zingales (1995) larger firm tend to be more diversified, have better
access to public debt markets and reduce the probability of the bankruptcy. With less risk,
larger firm have higher level of debt than small firm. Firm size positively correlated with
leverage as stated by Titman and Wessel (1988), Rajan and Zingales (1995)
(3.6)
3.3.4 Growth
The firm that expected high growth opportunities in the future tend to use great equity.
According to Titman and Wessel (1988) equity-controlled firms have tendency to invest
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
sub optimally to expropriate wealth from the firm‟s bondholders. The cost associated with
the agency relationship is likely to be higher for the firms in growing industries, which have
more flexibility in their choice of future investments. The firm that expected high expected
future growth should be negatively related to long-term debt levels.
(3.7)
3.3.5 Non Debt Tax Shield
Firm tend to use leverage because of the benefit from the non debt tax shield which is
reduction of the payment of the debt because of the firm must pay the interest. Non debt
tax shield is not only from the payment interest but also high depreciation cost, it will cost
less tax obligation to be paid for the firm. Faulklender, Flannery, Hankins and Smith
(2011) include this non debt tax shield variable on their research. Non debt tax shield
expected to be negatively related to leverage.
(3.8)
3.3.6 Liquidity
In dynamic trade-off research, liquidity of the company give big impact to the adjustment
of targeted capital structure. the company will adjusted their capital structure to the optimal
value if the benefit is greater than the cost. When the company in surplus, the company
with high leverage will use the cash to reduce the debt. Liquidity expected have negative
relationship toward leverage.
(3.9)
3.3.7 Dividend Payout
Dividend payment will reduce the internal finance for capital expenditures and will affect
the capital structure of the company. This will make the firm to use external financing to
operate the company and execute new investment. Dividend can be considered as proxy
from profitability because the source of dividend is from profit of the company so dividend
expected have positive relationship towards target leverage.
(3.10)
4. The findings
There are several table provide information about the empirical result. For table I
described about the correlation matrix for the independent variable, table II consist of the
summary statistics of the variables used in the research, table III is about the regression
analysis and the model description.
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
Table I. Correlation matrix of the independent variables
From the table I above we find that the correlation between independent variable is
relative low. The highest correlation is occur between variable dividend and profitability
with 0.61819, this occur because dividend can be considered as a proxy of profitability
because in general dividend is derived from profit of the firm. but the value of all the
variable above is less than significancy level (0.08) which means that there are no
multicolinearity occur in this research.
Mean
LEV
DIV
PROF
TANG
SIZE
GROWTH
NONDEB
T
LIQ
LEVLAST
Median
Maximum
Minimum
0.571209
0.245811
0.130827
0.286063
29.11585
1.741131
0.026859
0.55812
0.19984
0.095924
0.25122
29.1846
1.199409
0.021868
1.964403
2.012844
0.563112
0.862539
32.83653
15.00327
0.202369
0.107621
-0.04317
-0.07631
0.003955
22.72657
0.355608
-0.06535
Std.
Deviation
0.266769
0.281757
0.119831
0.193499
1.369691
1.815668
0.027327
0.109573
0.576162
0.063497
0.563895
7.341852
1.964403
-0.23604
0.107621
0.361247
0.264476
Table II. Summary statistics of the variables used in this research
The table above indicates that the typical of firm‟s target leverage varies a lot. From the
1996 begin with 56%, rises 196% and the end of period is 74% in 2013. The estimated
target leverage has an average 57% with standard deviation 26%.
LEV
DIV
PROF
TANG
SIZE
GROWTH
NONDEBT
LIQ
LEV
1.000000
-0.299151
-0.362629
0.098108
-0.208752
-0.214274
-0.087852
-0.016460
DIV
PROF
TANG
SIZE
GROWTH
NONDEBT
LIQ
1.000000
0.618191
0.155700
0.100806
0.473083
0.170999
0.132820
1.000000
0.198964
0.063198
0.599703
0.118649
0.240085
1.000000
0.188854
0.145234
0.526550
0.016294
1.000000
0.057735
0.308748
0.018590
1.000000
0.091211
0.155984
1.000000
-0.00693
1.000000
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
DIV?
PROF?
TANG?
SIZE?
GROWTH?
NONDEBT?
LIQ?
LEVLAST?
1.343553
-0.009025
-0.612699
0.091276
-0.038455
0.021844
-0.806724
0.038809
0.664649
0.472245
0.040959
0.130671
0.110948
0.015800
0.005749
0.330937
0.008470
0.085127
2.845032
-0.220350
-4.688851
0.822694
-2.433814
3.799901
-2.437695
4.582009
7.807746
0.0047
0.8257
0.0000
0.4112
0.0154
0.0002
0.0152
0.0000
0.0000
Effects Specification
Cross-section fixed (dummy variables)
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
0.776826
0.751906
0.132875
7.115277
293.3994
31.17259
0.000000
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
0.571209
0.266769
-1.102002
-0.681238
-0.936148
1.981664
Table III. Pooled Least Squared with fixed effect method result
Regression model for the table above :
4.1 Coefficient of Determination
From the result of regression estimation, the value of r2 is 0.776826. This value means
that the independent variables can explain 77.68% of determinant of the dynamic capital
structure, where the other 22.32% is explains by other variable.
4.2 T Test
T test is determine the significance level of each independent variables to the dependent
variable by comparing the p-value and significant level to know whether the hypothesis is
rejected or not. We use 0.05 significant level and the regression modle above shows that
LIQ (Liquidity) and GROWTH (Growth Opportunity) has positive and significant relation
toward LEV. TANG (Tangibility) has positive and no significant relation toward LEV. PROF
(Profitability), SIZE (Size of the firm), and NONDEBT (Non-debt tax shields) has negative
and significant relation toward LEV. DIV (Dividend payout ratio) has negative and no
significant relation toward LEV.
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
4.3 F Test
F test is measure the indication of independent variables toward dependent variable
whether it significance toward each other or not. F test use 0.05 significant level , with
hypothesis :
H0 : DIV, PROF, TANG, SIZE, GROWTH, NONDEBT, LIQ has no significant influence
toward dependent variable
H1 : DIV, PROF, TANG, SIZE, GROWTH, NONDEBT, LIQ has significant influence
toward dependent variable
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
0.776826
0.751906
0.132875
7.115277
293.3994
31.17259
0.000000
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
0.571209
0.266769
-1.102002
-0.681238
-0.936148
1.981664
as we can see from the table above, the probability (F-statistic) < 0.05 which means we
reject H0. All the independent variable has significant influence toward Leverage.
4.4 Adjustment capital structure
From the table III shows the estimatest that 1-λ is 0.664649 and the speed of adjustment
can also be converted in 2.98 year (1/λ) which imply that firms have 33.55% the gap
between current and desired leverage within one year or equivalent to 2.98 year to fully
reach target leverage. this result show rapid adjustment toward a firm-specific capital ratio
suggest the existence of trade-off theory which state that firm have targeted capital
structure and wish to return to those targets when the cost and benefits is optimal. This
adjustment show positive sign also confirms that there will be adjustment by the firm to
return to its optimal capital structure. these finding are accordanve with previous research,
like Flannery and Rangan (2006), Faulklender, et al (2008).
4.5 Determinant of target leverage
The table above also explain the relationship status for each determinant of target
leverage.
4.5.1 Profitability
The regression coefficient of profitability shows negative relationship with value of the
coefficient -0.6127 toward target leverage and statistically significant. This support the fact
that the higher the profitability of the company, the lesser the company use external
financing. This result also provide information that profitable company prefer to use
internal financing than external funds and support pecking order theory. This result is
accordance to previous studies by Titman and Wessel (1998), Harris and Raviv(1991),
Rajan and Zingales (1995), and Frank and Goyal (2003).
Proceedings of 7th Asia-Pacific Business Research Conference
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4.5.2 Non-Debt Tax Shield
Non-debt tax shield coefficient shows negative relation with value of the coefficient
-0.8067 and statistically significant toward target leverage. This can be implied for the
reduction of debt payment because of benefit from tax shield. This result support the
finding from previous studies by Faulklender et al (2008).
4.5.3 Size of the firm
Size of the firm coefficient shows negative relationship with value of the coefficient
-0.03845 and statistically significant toward target leverage. This result is accordance with
the previous finding by Titman and Wessel (1998), Rajan and Zingales (1995). This result
may support the fact that there is information assymetry between firm insiders and capital
markets are lower for the large firms, so that large firms more capable to issuing equity.
Besides of that, this result may be imply bigger firms have high internal cash for the new
investment.
4.5.4 Growth
Growth opportunity coefficient shows positive relationship with value of the coefficient
0.02184 and statistically significant toward target leverage. This result imply that the
growing firm may find it easier to change the capital structure by issuing new debt or other
external leverage. this result also support the pecking order theory as studied by Booth et
al (2001)
4.5.5 Liquidity
Liquidity coefficient shows 0.038809 which mean have positive relationship and
statistically significant toward target leverage with value 0.000 lower than significant value.
This can be implied that firm with high liquidity tend to use liabilities to finance their asset
and this make leverage become high.
4.5.1 Tangibility and Dividend pay out
It is found that the coefficient of tangibility is not significant toward target leverage with
positive relationship and Dividend payout coefficient shows value -0.009025 have
negative sign and statistically significant toward target and not significant toward target
leverage with value 0.8257. This two variable have no significant toward the dependent
variable because the value is higher than significant level(0.05).
5. Summary and Conclusions
This study explained about the dynamic tradeoff capital structure to study the adjustment
speed of firms toward their target capital structure. Using sample data from Indonesian
firms consist of 38 Firms from different sector, we found that the dynamic model
regression support the previous study about existence of leverage as hypothesized in
trade-off theory. Besides of the adjustment speed toward capital structure, this study also
find out firm-specific which affect the leverage ratio of the company and their relationship
status toward target capital structure. The result of this study shows us the adjustment
speed towards target capital structure is at level 33.5% or equivalent to 2.98 year to fully
reach target leverage which validated that there is an optimal capital structure and they
want to achieve it.
Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
The result for firm-specific factor towards target capital structure shows profitability, nondebt tax shields, size of the firm, growth opportunity, and liquidity has significant relation
toward target leverage. while dividend pay out, and tangibility has no significant relation
toward target leverage.
By finishing this result, we suggest that the managerial and decision maker of the
company take into account the variable that have significant relation toward target
leverage. the three highest variable that have significant relation toward leverage are
Profitability, Non-debt tax shield, and liquidity. This result also bring some managerial
implications based on our study, the management should understand the position of the
company leverage, wheter it is lower or over than expected leverage because the good
managerial will utilize the tax-shield and aware of high financial distress. the management
should calculate the benefit and cost to choose the leverage by doing cash management
and properly calculate investment decision.
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