Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
Testing Static Trade-Off Theory in Indonesian Listed Firms
(Case Study Period 1995 – 2012)
Tiffany Chrisy Monika Sitompul* and Ir. Subiakto Soekarno**
One of the most important decisions in corporate finance is financing decision. Financing
decision is related on how a firm finance its operational, whether from debt or equity. This
decision is shown from its capital structure. Capital structure is the proportion of mix
between debt and equity. As the objective of a firm is to maximize shareholder’s wealth,
firms tend to find the right proportion of debt and equity.
The study of capital structure is still evolving until now. Several renowned theories of
capital structure are The Modigliani-Miller Theorem, Trade-off Theory, Market Timing,
Signaling, and Pecking Order Theory.
This research aims to assess whether Indonesian listed firms follows Static Trade-off
Theory. Static Trade-off Theory supports the presence of optimal capital structure by
balancing the cost and benefit of debt. Firms will try to remain close to its target capital
structure. Six variables: dividend payout ratio, profitability, asset intensity (tangibility), firm
size, growth opportunities and initial leverage will be investigated toward the dependent
variable, in the form of firm’s leverage ratio.
Secondary data of financial report is used in this research. Panel data regression will be
the statistical tool. Panel data is combination of time-series and cross section data. The
sample of this research is firms listed in LQ45 index from February to June 2014 with the
exception of non-financial companies. 39 firms are chosen as sample. The period of this
research will be from 1995 until 2012.
The result shows that dividend payout ratio, profitability, asset intensity, firm size and
initial leverage are significant factor to firms’ capital structure decision. Dividen payout
ratio, asset intensity and initial leverage are consistent with Static Trade-off Theory.
Keywords: Capital Structure, Static Trade-off Theory, Indonesia
Field of Research: Finance
1. Introduction
In corporate finance, there are three main principles that affect firms’ performance.
According to Damodaran (2006), those principles are investment principle, financing
principle and dividend principle. Investment decision is related to in which investment firms
spend its capital. The return of investment must surpass the minimum hurdle rate, so it is
important to choose the right investment decision. Financing principle is related to how
firms fund its investment decision. Financing principle is shown by its capital structure.
Lastly, dividend principle is about the way to return the excess cash to shareholders. In
this research, the observation will be focused on the financing principle by discussing
firms’ capital structure.
The theories of capital structure have been developed until now. The theories of capital
structure aims to find the right proportion of debt and equity in order to fund company’s
operation. The debate of capital structure began with the theory of Modigliani-Miller.
*Tiffany Chrisy Monika Sitompul, School of Business and Management, Institut Teknologi Bandung,
Indonesia. Email: chrisy@sbm-itb.ac.id
**Ir. Subiakto Soekarno, MBA., School of Business and Management, Institut Teknologi Bandung, Indonesia.
Email: subiakto@sbm-itb.ac.id
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
There are lot theories since then but two theories that dominate the research related to
capital structure are Static Trade-off Theory and Pecking Order Theory. Static Trade-off
Theory supports the presence of optimal leverage level by trading the benefit and cost of
debt. On the contrary, Pecking Order Theory does not support target capital structure.
This theory stated that firms tend to use funding from internal, rather than external source.
This research will focus on one theory which is Static Trade-off theory. The model of this
research is adopted from Rajan and Zingales (1995) that used four variable which are firm
size, growth opportunities, tangibility (asset intensity) and profitability. But, this research
will add another two variables which are dividend payout ratio and initial leverage. These
two variables are rarely used in previous research related to this theory.
Several studies have been conducted about examining capital structure decision in
Indonesia, particularly related to Static Trade-off Theory. Several of them only determine
the determinant of capital structure in certain industry. Some studies also compared static
trade-off theory with Pecking Order Theory to see which theory represents the behavior of
Indonesian firms. Darminto and Manurung (2008) stated that in industrial firms in
Indonesia, static trade-off theory outperformed Pecking Order Theory. Moreover, Ang et al
(1997) found evidence that firms in Indonesia have target capital structure, even though it
is considered weak. Firms operate in behavior as if the optimal structure is existed.
Because of that, the author wants to investigate to what extent firms in Indonesia follow
static trade-off theory. The second section will contain the literature review, and will be
followed by methodology and model used, findings, and conclusion.
2. Literature Review
2.1 Capital Structure Theories
2.1.1 Modigliani Miller Theorem
This theory was the first breakthrough theory of capital structure decision. The core of this
theory is the irrelevance proposition that provides conditions under which a firm’s financial
decisions do not affect its value. The theory was made using these following assumptions:
market is perfect and frictionless, there is no transaction costs, no tax, no default risk, and
both firms and investors can borrow at the same interest rate.
In 1963, Modigliani and Miller sensed the importance of corporate tax and include tax into
their propositions. After the presence of tax, the value of firms that use debt (levered) is
higher than unlevered firms since tax deducts interest payment. The decision of debtequity ratio affects firms’ market value. This leads to the conclusion that firms will likely to
use debt rather than equity in its financing. However, this theory did not consider
bankruptcy cost and financial distress that will occur if firms use too much debt.
2.1.2 Static Trade-off Theory
Trade-off theory was developed after the debate of Modigliani-Miller proposition. This
theory states that there is an optimal capital structure. The optimal capital structure can be
obtained by balancing the benefit of debt and cost related to debt issuance which will help
firms maximizing its value. The benefit of debt mostly comes from interest payment. Debt
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
has a role as the tax shield which deducts the payment of interest. On the contrary, debt
will add the cost of financial distress, especially when firms use too much debt. Costs of
financial distress include the legal and administrative costs of bankruptcy, as well as the
subtler agency, moral hazard, monitoring and contracting costs (Myers, 1984).
An important point of the static trade-off theory is that firms target their capital structures.
“If the actual leverage ratio deviates from the optimal one, the firm will adapt its financing
behavior in a way that brings the leverage ratio back to the optimal level” (Luigi and Sorin,
2009). Because of that, proper debt ratio must be achieved as its long-term goal.
2.1.3 Pecking Order Theory
Pecking Order Theory is driven by asymmetric information theory. Asymmetric information
is based on the opinion that managers tend to have more information if compared to
external investors. The Pecking Order Theory prefers to fund new investment using
internal fund, rather than external fund. Therefore, firms will choose to use internal fund
with retained earning first, then use short-term debt with no collateral required, then longterm debt and last use equity since equity has high cost on the issuance.
According to Myers (1984), it is hard to determine the optimal debt-equity ratio because
the theory considers source of fund as internal and external, rather than debt and equity.
On the contrast of trade-off theory, in Pecking Order Theory, firms have no optimal capital
structure or target leverage.
2.1.4 Market Timing
This theory was developed since the paper of Baker and Wurgler (2002). This theory also
stated that there is no optimal capital structure. According to them, “capital structure
evolves as the cumulative outcome of past attempts to time the equity market”. The timing
is when managers think that the stock is overvalued, they issue new stock and when the
stock is undervalued, they buy back firms’ shares.
They found that the leverage is strongly and positively relate to its market timing. In their
paper, Baker and Wulger found that the fluctuation in market valuation have large effect
on capital structure. This finding persists for over a decade. Still, this theory is lacking in
the theoretical model.
2.1.5 Signaling
Signaling theory stated that firms’ financial decision is a signal to investors about firms’
future prospects. This theory is able to reduce the problem of information asymmetry. This
theory was published by Ross (1977). Investors are concerned of firms’ debt level
because the quality of firms is determined by its debt level. The issuance of debt gives
signal to investors that firms have high quality and also gives positive market reaction. The
issuance of equity, on the contrary, gives negative market reaction and investors tend to
presume that the firm has low quality because lower quality firm have higher marginal
expected bankruptcy cost and do not think to issue more debt and choose equity instead.
2.2 Determinants of Capital Structure
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
2.2.1 Dividend Payout Ratio
Dividend payout is how much cash to be distributed from firms’ profit. Higher profit creates
excess cash which will result on agency conflict. This excess cash will give managers two
options, which are to lower the dividend payment to discipline shareholders or increase
debt since debt can reduce agency cost as stated by Static Trade-off Theory. The
dividend has inversely correlated to debt (Jensen, 1986). Therefore, dividend is expected
to have negative relationship to leverage level as previously researched by Frank and
Goyal (2003).
2.2.2 Profitability
Profitability is the relationship between profits generated from firms’ profit. In static tradeoff theory, profitability is the sign that firms are able to pay the debt and gives more
flexibility to increase the use of debt. According to Booth et al (2001), when profitability
decline, the expected bankruptcy cost will increase, so it forces firms lower the leverage
level. Firms with higher profit will also have more free cash. This free cash can cause
conflict between managers and shareholders, so managers tend to use more debt in order
to solve this conflict. Therefore, profitability is expected to have positive relationship
towards firms’ leverage level.
2.2.3 Asset Intensity
Asset intensity measures the tangible asset that firms have so the term is usually stated
as tangibility. Tangible asset is related to collateral in order to issue loan or debt. Tangible
asset is easy to be collateralized and they can reduce the agency costs of debt, as stated
by Rajan and Zingales (1995). The more tangible asset firms have, the easier firms can
acquire debt since lenders favor firms with many tangible asset. Because of that, in Static
Trade-off Theory, asset intensity will have positive relationship to leverage level.
2.2.4 Firm Size
Firm size has positive relationship towards leverage level as previously stated by Titman &
Wessels (1988), Rajan and Zingales (1995), and Booth et al (2001). Larger firms have
lower risk of bankruptcy since larger firms can diversified to avoid bankruptcy. Besides
that, larger firms are able to issue debt with lower cost compared to smaller firms. Hence,,
larger firms are expected to have higher leverage level.
2.2.5 Growth Opportunity
Growth opportunity uses market-to-book ratio as proxy. This variable is negatively related
to firms’ leverage level. First reason is that firms that equity-controlled tend to invest
suboptimally to expropriate wealth from shareholders (Titman and Wessel, 1988). This will
lead to high agency cost. Other than that, a growth opportunity is considered as intangible
asset so it will have opposite effect from tangible asset. High expected growth opportunity
can no be collateralized. Therefore, firms with high growth opportunity will have low
leverage level.
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
2.2.6 Initial Leverage
Initial leverage is the leverage level that firms use when they sell their stocks for the first
time, or it is stated as Initial Public Offering (IPO). In time of IPO, firms tend to show its
best condition to public, so it can be assumed that firms use their optimal leverage level.
This relationship was explained by Lemmon, Roberts, and Zender (2006). They stated
that initial leverage was statistically significant towards future leverage ratio.
3. The Methodology and Model
3.1 Data Collection
This research will use secondary data from firms’ financial report. Financial reports are
obtained from Indonesia Stock Exchange and Indonesia Capital Market Library. The
author uses stocks in LQ45 index with the exception of financial related sector as sample
with the time period from 1995 to 2012. The reason of choosing LQ45 as sample is
because LQ45 firms own 70% of market capitalization of all listed firms in Indonesia and it
is expected to capture all the Indonesian listed firms.
3.2 Variables
3.2.1 Dependent Variable
Dependent variable used in this research is firms’ leverage level which will be measured
as debt ratio. Among many approaches to measure this, this research will use debt ratio
as ratio of total debt per total asset. This ratio can overcome problem of conflicting result
between short-term debt and long-term debt in leverage measurement.
3.2.2 Independent Variable
This research will use six variables as independent variables. These variables are adopted
from the previous study by Rajan and Zingales (1995) with the addition of two variables.
Those variables are dividend payout ratio, profitability, asset intensity, firm size, growth
opportunities and initial leverage.
3.3 Regression Model
To run regression analysis, the author use Eviews software. Data panel regression
method is chosen as statistical tool in this research. Data panel combines time series and
cross section data. There are three approaches in data panel. They are pooled least
square, fixed effect, and random effect. To determine the best approach for this research,
Hausman test is used. The result of Hausman test shows 0.0567 of probability. This
number is greater than significant level of 0.05, so the best approach is to use random
effect approach.
The regression model with the variables described below:
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
LEVit = it + 1DIVit + 2PROit + 3INTAit + 4GROWTHit + 5SIZEit + 6INLEVit + it
LEVit is leverage level for firm i in period t
DIVit is dividend payout ratio for firm i in period t
PROFit is profitability for firm i in period t
INTAit is asset intensity for firm i in period t
GROWTHit is growth opportunities for firm i in period t
SIZEit is firm size for firm i in period t
INLEVit is initial leverage for firm i in period t
it is coefficient intercept
it is random error term for firm i in period t.
4. The findings
4.1 Analysis from Coefficient of Multiple Determinations R2
According to Gujarati (2004), coefficient of determination is “a summary measure that tells
how well the sample regression line fits the data”. It is stated as R2. R2 value from
regression model is 0.2356. This number shows that 23.56% of leverage level for
Indonesian listed firm is explained by variables used in this research. While the rest of is
captured by other variables that are not included in the regression model.
4.2. Analysis using t-test
The result of regression is shown on table below:
Tabel 1. Regression Result
Variable
C
DIV?
PRO?
INTA?
GROWTH?
SIZE?
INLEV?
Coefficient
1.930624
-0.247268
-0.539192
0.303149
0.005496
-0.050589
0.333281
t-Statistic
4.441299
-2.549947
-3.882545
3.212465
1.095014
-3.615467
3.657875
Prob.
0.0000
0.0111
0.0001
0.0014
0.2741
0.0003
0.0003
Based on the regression result, the regression model for this research is:
LEV = 1.930624 - 0.247268DIVit - 0.539192PROit + 0.303149INTAit + 0.005496GROWTHit
- 0.050589SIZEit + 0.333281INLEVit + it
The p-value of dividend payout ratio is 0.0111, which is lower than significant value of
0.05. It means that dividend payout ratio has significant impact on leverage level. The
coefficient also shows negative relationship between dividend payout ratio and leverage
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
level. This result supports the Static Trade-off Theory since it is stated before that dividend
and leverage level have inverse relationship.
Profitability has p-value of 0.0001, which also lower than significant value of 0.05.
Therefore, profitability also gives significant impact to firms’ leverage level. However, the tstatistic shows that profitability and leverage level have negative relationship towards
leverage level. It is not consistent with Static Trade-off Theory. This results show that high
profitable firms tend to lower its leverage level and use retained earning. It is already
predicted by Pecking Order Theory.
Asset intensity has t-statistic of 3.212465 with p-value of 0.0014. The p-value is smaller
than significant level of 0.05. Asset intensity shows significant impact to leverage level.
The relationship between asset intensity and leverage is shown as positive. It is
correspond to Static Trade-off Theory. Firms in Indonesia tend to issue more debt when
they have high tangible asset since it can be used as collateral.
Growth opportunity is not significantly affect firms leverage level. It is shown from its tvalue of 1.095014 and p-value of 0.2741, which is greater that significant level of 0.05. It
also shows the positive relationship towards leverage level. The result is not consistent to
Static Trade-off Theory or Pecking Order Theory. Both of the theory stated that firms with
high growth opportunities tend to lower its leverage level. The positive result may be
explained by signaling model. High growth opportunity means that firms expect good
future performance. It makes firms are easier to obtain long-term debt.
For firm size, the p-value is 0.0003, lower than significant level of 0.05. It indicates that
firm size is a significant factor in determining leverage level. The result points out that firm
size has negative relationship with leverage level. It is also in contrast with Static Trade-off
Theory. This negative relationship is explained by Rajan and Zingales (1995). They stated
that larger firms tend to reveal information to outsider so they operate with less problem of
assymetric information. This causes firms to use more equity than debt.
Initial leverage has t-statistic of 3.657875 with p-value of 0.0003 which greater than
significant value of 0.05. This indicates that initial leverage has significant impact on
leverage level. Initial leverage is shown to have positive relationship with leverage level
which is consistent with Static Trade-off Theory.
4.3 The overall f-test
F test is measure the indication of independent variables toward dependent variable
whether it significance toward each other or not by controlling the other independent
variables. F-value from statistical test is 23.6809, while the f-value table is 1,35. The Fvalue from statistical test is greater. It indicates that all six variables used are
simultaneously having significant impact to leverage level of Indonesian listed firms.
5. Summary and Conclusions
This research aims to find what factor affecting the capital structure decision in Indonesian
listed firm from 1995 until 2012. Sample of this research is firms listed in LQ45 index with
the exception of financial related firms. The statistical tool for this research is panel data
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
regression. Factors to be observed are dividend payout ratio, profitability, asset intensity,
growth opportunities, firm size, and initial leverage.
The regression result shows that Indonesian listed firms partially follow Static Trade-off
Theory. Three variables: dividend payout ratio, asset intensity and initial leverage are
consistent with Static Trade-off Theory. All of them are also have significant impact to
leverage level. While the other three variables: profitability, growth opportunities and firm
size are contrast with Static Trade-off Theory. Even though it is not consistent with Static
Trade-off Theory, profitability and firm size are considered as significant factor for
leverage level. Growth opportunity, on the contrary, does not show significant effect for
leverage level. Overall, the variables captured 23.56% of leverage level, when the other
76.44% is explained by other factors.
The result of this research can be used as contribution in the existing study of capital
structure, especially to those who are interested in developing country like Indonesian. It is
also expected to help financial managers get a better understanding on capital structure
decision and able to make appropriate decision and policy on its financing mix in order to
achieve firms’ goal to maximize shareholders’ wealth. For further research, additional
variable may be able to explain deeper about firms’ capital structure.
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Proceedings of 7th Asia-Pacific Business Research Conference
25 - 26 August 2014, Bayview Hotel, Singapore ISBN: 978-1-922069-58-0
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