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 25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0 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. References Baker, M., & Wurgler, J. (2002). “Market timing and capital structure”. The journal of finance, vol. 57, no.1, 1-32. Fama, E. and French, K. 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