Journal of Asia Business Studies

Do Indonesian firms practice target capital structure? A dynamic approach

Razali Haron
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Razali Haron , (2016),"Do Indonesian firms practice target capital structure? A dynamic approach", Journal of Asia Business
Studies, Vol. 10 Iss 3 pp. -
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http://dx.doi.org/10.1108/JABS-07-2015-0100
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 Do Indonesian firms practice target capital structure?
A dynamic approach

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-
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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, 2009). Nonetheless, no universal consensus on the perfect debt and equity ratio
has been reached so far for a firm to employ 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 (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 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
follows 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 is 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) on
the 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. Firm
with a history of strong stock price will issue more equities and less debt whereas a less
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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 studies done 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 realise 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 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.
Realising that, a partial adjustment model of capital structure has then begun to attract
considerable attention (see for examples, 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 (see, for examples, Drobetz and Wanzenried, 2006; Aybar- Arias et
 al., 2011; Oztekin and Flannery, 2012; Haron et al., 2013a; Haron, 2014a; Haron, 2014b;
Daher et al., 2015). Recent studies validated the impact of deviation cost on adjustment speed
(see for examples, Aybar Arias et al., 2011; Oztekin and Flannery, 2012; Haron, 2014b).
Adjustments toward a target can be asymmetric depending on how individual firm weighs the
degree of deviation of its leverage from target. When the deviation cost is relatively higher the
firm would opt to remain off the target. On the other hand, if the benefit of being at the target
leverage is substantially higher, the firm would rebalance instantaneously. Haron et al.
(2013a) argue that adjustment speed is also influenced by the debt level of the firm. Firms
taking on less debt (under-levered) in their capital structure appeared to rebalance faster as
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compared to the over-levered firms. This indicates that the cost of deviation from target
leverage is relatively higher when firms are over-levered than when they are under-levered.

Nevertheless, the body of knowledge has been documenting studies on target capital structure
with developed economies monopolizing the attention of researchers over the years (Ramjee
and Gwatidzo, 2012) leaving the emerging markets far behind (Lemma and Negash, 2014).
The scarcity of capital structure studies on emerging market, according to Eldomiaty (2007) is
mainly attributed to three main reasons. Firstly, capital markets in emerging markets are
relatively less efficient and incomplete than the developed markets causing financing decision
to be incomplete and subject to irregularities. Due to that firms in emerging markets may face
difficulties to decide on which capital structure financing to employ. Therefore, for this
reason, comprehensive understanding on the capital structure behaviour is very much required
in an emerging market in order to understand the influencing factors on corporate financing in
this type of market. Secondly, in emerging market, information asymmetry is noticeably
higher. This will result in emerging market not readily markets for raising financing due to its
inefficiency and this could lead to a none optimal financing decision. Thirdly, there is a need
to develop literature on capital structure in emerging markets which have different
institutional financing arrangements form those in developed markets. Ramjee and Gwatidzo
(2012) agree to Eldomiaty (2007) that emerging market is less efficient, having higher
information asymmetry, thus there is a dire need to develop extensive and comprehensive
literature due to the different financing arrangements from those of the developed market.

Indonesia, being an emerging market is no less suffering from the scarcity of capital structure
studies (Tzang et al., 2013). Studies like Setyawan and Hartono (2001); Bunkanwanicha et al.
(2008); Ruslim (2009); Setyawan and Budi (2012) and Manurung (2012) have indeed
 contributed to the literature of corporate financing when they examine the contributing factors
of the capital structure in Indonesia. Nevertheless, by employing the static model, they are not
able to confirm the existence of target capital structure, to capture the magnitude of
adjustment speed and the adjustment cost that a firm may be facing. Moosa and Li (2012)
agree to the fact that Indonesia receives very little attention in relation to studies of capital
structure, especially using the dynamic model to capture the adjustment process of the firms.

This study, therefore, has chosen Indonesia, an emerging market as a showcase to the capital
structure behaviour. Indonesia is the largest national economy in Southeast Asia (Baker and
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Powell, 2009) but relatively a closed economy compared to its Southeast Asian neighbours
(Tambunan, 2010). Being a closed economy Indonesia has indeed benefited a lot from the
reformation of its domestic financial sector, thus consequently affected the firms’ financing
decisions (Ameer, 2010).

The Indonesian financial markets were deregulated beginning of 1983 due to a lot of flaws
and weaknesses in the firms’ financing choices. The state-owned banks dominating the debt
market had led firms resorting to only the state-owned banks for financing source. Retained
earnings or any other sources of capital would come later. Indonesia again experienced
another reformation when starting from 1988 private domestic and foreign banks were given a
status quo with the state-owned banks for loans priced at market rates (Moosa and Li, 2012).
Control over initial offering prices and the daily movement of stock prices was lifted,
providing a fair game between the state and private banks, the choices between debt and
equity as well as between internal and external sources of equity. Ameer (2010) states that the
reformation of financial sector in Indonesia involves interest rate liberalization (1983),
removal of entry barriers (1988), increase of scope of banking services (1988), reduction of
reserve requirements (1988), equity market opening (1989), removal of credit controls (1990),
the launch of first country fund (1991), privatization of state-owned enterprises (1991),
privatization of state-owned banks (1992), introduction of foreign investor incentives (1994),
first cross listing (1994) and introduction of prudential regulations (1997).

However, the 1997/1998 Asian financial crisis which severely impacted East and Southeast
Asian countries, has left a damaging scar to Indonesia, being one of the most badly hit by it.
The Indonesian economy had plunged into a deep recession in 1998 with overall growth at
minus 13.7 percent. Triggered by a sudden capital flight from the country, rupiah has
 depreciated substantially against the US dollar. The depreciation then led to national banking
crisis and had consequently caused national economic crisis. By the end of 1997, sixteen
commercial banks were closed, and access to credit became very difficult and interest rate
increased significantly (Tambunan, 2010). This was a very severe situation as after the
financing reformation, financings were mainly dependent on credit from banks or other
financial institutions. This has contributed significantly to output contractions in many sectors
in Indonesia. These financing reformations and the impact of the Asian 1997/1998 financial
crisis thus provide interesting platform for further investigations on capital structure theories
and this study acknowledges that. The capital structure theories were developed without
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bearing in mind the emerging market thus this study is highly motivated to investigate the
capability of these theories in explaining the capital structure behaviour of firms in the
emerging market, of which the institutional environment may not be the same as those in
developed market.

Realising the significant financing reformation, the impact of the 1997/1998 financial crisis,
and the fact that Indonesia receives very little attention in the study of capital structure, this
study aims to fill this gap in the literature, offering an extension to the existing body of
knowledge and providing better insights through the lens of the dynamic model. The
identification of target capital structure and its influencing factors will gear firms to move
forward and strive for value maximization, thus this study is motivated by that objectives. A
partial adjustment model estimated based on a generalized method of moments (GMM)
technique is employed to examine the existence of target capital structure and the influencing
factors, the speed of adjustment when firms are deviated from the target and the capital
structure theories supporting the findings.

This study contributes significantly to the body of knowledge of capital structure studies in
Indonesia by utilizing relatively recent data (2000-2011) with bigger sample of 365 listed
firms in comparison to the previous limited empirical studies on Indonesia, for examples,
Moosa and Li, 2012 (2009, 162 firms); Manurung, 2012 (1990-2010, 120 firms); Setyawan
and Budi, 2012 (2008-2009, 52 firms), Ameer, 2010 (1991-2004, 116 firms), Ruslim, 2009
(2000-2007, 18 firms); Bunkanwanicha et al., 2008 (1992-1998, 180 firms); De Jong et al.,
2008 (1997-2001, 177 firms); Setyawan and Hartono, 2001 (1996-2000, 51 firms).
 This study is organized as follows: the next session covers the literature review of the
determinants of target capital structure and the development of hypotheses then followed by
data and methodology. Next is the analysis and findings and the final section discusses the
overall conclusion of the study.

2. Review on Determinants and Hypotheses Development

Several important determinants have been recognized in the literature as being influential in
capital structure decisions and represent different arguments relating to the domineering
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capital structure theories. These include non-debt tax shield (NDTS), profitability, tangibility,
liquidity, firm size, growth opportunity, business risk and share price performance (see, for
examples, Harris and Raviv, 1991; Rajan and Zingales, 1995). These factors are part of what
Frank and Goyal (2009) have identified as the core factors of leverage and Bessler et al.
(2011) highlight that these factors are among the factors that are frequently used in empirical
capital structure research.

2.1 Non Debt Tax Shield (NDTS)

After the perfect market assumption in their 1958 study, Modigliani and Miller have lifted the
assumption and included taxes in the sequel of their capital structure study in 1963 showing
that debt could yield substantial gains from the tax shields. However according to DeAngelo
and Masulis (1980) the benefits of tax shield from debt financing do encourage firms to
include more debt in their capital structure but firms may encounter the danger of default in
interest payment thus may lead to financial distress and bankruptcy risk. Firms, on the other
hand, may choose other ways such as tax loss carry forward, investment tax credits and
depreciation to shelter income instead of the tax benefit from the use of debt financing. These
firms therefore will take on less debt in their capital structure. DeAngelo and Masulis (1980)
opine that these NDTS are the alternatives to tax shields provided by debt financing, hence a
negative relationship between NDTS and leverage should be expected. Setyawan and Hartono
(2001) and Ameer (2010) report significant negative relationship between NDTS and leverage
in their studies on Indonesian firms. NDTS is represented by annual depreciation expenses to
total asset (DeAngelo and Masulis, 1980). Thus following the literature, this study
hypothesizes that:

H1: NDTS has a negative influence on target capital structure.

 2.2 Profitability
Asymmetric information problems drive firms to opt to internal resources first when deciding
on investment financing as these are the cheapest funds (Myers and Majluf, 1984). Therefore,
firms with high profit and cash flows will finance investment with retained earnings rather
than using external financing, either debt or equity. Profitability thus affects leverage
negatively indicating the support of the POT. Bunkanwanicha et al. (2008), De Jong et al.
(2008), Ameer (2010) and Moosa and Li (2012) record significant negative relationship
between profitability and leverage in their studies on Indonesian firms. Firm’s profitability is
represented by earnings before interest and tax (EBIT) over total asset (Rajan and Zingales,
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1995). For this variable, this study hypothesizes that:

H2: Firm’s profitability has a negative influence on target capital structure.

2.3 Business Risk

Earnings volatility represents business risk of firms. Firms with a high degree of earnings
volatility in their operation may face default on debt payments, therefore should opt for less
debt financing. This indicates a negative relationship with leverage. De Jong et al. (2008) and
Ameer (2010) find significant negative relationship between business risk and leverage in
their studies on Indonesian firms. For business expansion and competencies, equity issuance
would be the preferred funding over debt for firms with high risk. Hence, equity holders
would seek for higher return as compensation to the higher risk taken on investment. Business
risk is represented by yearly change in the firm EBIT (Deesomsak et al., 2009). Thus, the
hypothesis for this variable is that:

H3: Business risk has a negative influence on target capital structure.

2.4 Tangibility
The TOT suggests that tangibility relates positively with leverage as firms with high tangible
assets[1] can tender these assets as collateral. Debt is then less risky and consequently lenders
will lend more. The higher tangible assets they have the more debt they can take on in their
capital structure. Assets that are tangible are more desirable from the point of view of lenders
because they are easier to repossess in bankruptcy. Hence a positive relationship is expected.
Bunkanwanicha et al. (2008), De Jong et al. (2008) and Moosa and Li (2012) document
significant positive relationship between tangibility and leverage in their studies on
 Indonesian firms. Tangible asset is represented by net fixed asset over total asset (Rajan and
Zingales, 1995; De Jong et al., 2008). Therefore, this study hypothesizes that:

H4: Asset tangibility has a positive influence on target capital structure.

2.5 Firm Size

Size of firm is also anticipated to have an impact on leverage. Larger firms tend to be more
diversified and fail less often thus have bigger capacity to consume higher leverage. This
indicates a positive relationship which supports the TOT. Looking at the asymmetric
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information, the information asymmetry level in the market will be much lower for larger
firms since more information is expected to be available for these firms. With a much lower
level of asymmetric information, it is more possible for these larger firms to turn to debt
financing, hence a positive relationship. De Jong et al. (2008) and Ameer (2010) find
significant positive relationship between firm size and leverage in their studies on Indonesian
firms. Firm size is represented by natural logarithm of total asset (Deesomsak et al., 2009). As
for this variable, the hypothesis is that:

H5: Firm size has a positive influence on target capital structure.

2.6 Growth
For growth firms, huge capital funds will be needed by firms to capture all growth and
investment opportunities. According to the agency theory, these firms will be more inclined to
lower their debt level and opt to equity issuance as a gesture showing that they are not facing
underinvestment and asset substitution problems. This indicates a negative relationship. The
negative relationship is also in line with POT as the theory suggests that when investment and
growth opportunities are smaller than the retained earnings, debt ratios will be decreased. For
a given profitability, debt ratios are lower for firms with more growth opportunities (Myers
and Majluf, 1984). De Jong et al. (2008) detect a significant negative relationship between
growth and leverage on Indonesian firms. Growth is represented by market value of equity
over book value of equity (Rajan and Zingales, 1995). This study then hypothesizes that:

H6: Firm growth has a negative influence on target capital structure.

 2.7 Liquidity
Liquidity affects leverage negatively as the more liquid the firm the more internal funds will
be available to the firm thus the need for debt financing will be minimal. POT explains that
firms with higher liquidity prefer to use internally generated funds when financing new
investments and this notion is then confirmed by Deesomsak et al., 2009 and Moosa and Li,
2012. Thus, a firm’s liquidity position would have a negative impact on its leverage. Firm
liquidity is represented by current asset to current liabilities (Deesomsak et al., 2009; Moosa
and Li, 2012). This study hypothesizes that:
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H7: Firm liquidity has a negative influence on target capital structure.

2.8 Share Price Performance

When a firm records a strong share price performance with the present market values
relatively higher than the past market values, the firm is more inclined to issue equity whereas
when the present market values are comparatively low the firm will, on the other hand,
repurchase equity. This notion is based on the market timing theory indicating a negative
relationship between share price performance and leverage. Setyawan and Budi (2012) find a
significant negative relationship between share price performance and leverage on Indonesian
firms. Share price performance is represented by yearly change in year-end share price
(Deesomsak et al., 2009; Moosa and Li, 2012). The hypothesis for this variable is that:

H8: Share price performance has a negative influence on target capital structure.

Table I summarizes the explanatory variables and measurement used in this study, the
hypotheses developed and the predicted signs as documented in the literature.

Insert Table I

3. Data and Methodology

This study analyzes 365 non-financial listed Indonesian firms between 2000 and 2011 with
firm data extracted from the Datastream. The chosen study period is 2000-2011 because this
study intends to begin the data 2 years after the 1997/1998 Asian financial crisis and ends at 2
years after the 2008/2009 global financial crisis. These two financial crisis mark different
 impacts to Indonesian economic standing and may provide an interesting platform for the
capital structure analysis (see, Tambunan (2010) for detail explanation of the two financial
crises and impacts on Indonesia).

For observation purposes, only firms with a minimum of three consecutive observations
toward the end of the period are included in the data set (Deesomsak et al., 2009). This means
that the firms should at least be listed on the Indonesian Stock Exchange from the year 2009.
To meet its objective, this study employs the Generalized Method of Moments (GMM)
estimator proposed by Arellano and Bond (1991). Leverage in this study, as applied in other
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capital structure studies, is defined as the ratio of total debt to total asset (TD/TA) (see, for
examples, Titman and Wessels, 1988; Bunkanwanicha et al., 2008; Manurung, 2012). Table II
details the structure of the panel data of this study. The panel data is unbalanced because not
all firms have data for every year.

Insert Table II

3.1 Target Capital Structure Model

The theoretical literature investigating target (optimal) capital structure utilizes a dynamic
partial adjustment model to control for adjustment costs that firms may face in moving
towards their optimal capital structure (see for examples, De Miguel and Pindado, 2001;
Drobetz and Wanzenried, 2006; Oztekin and Flannery, 2012). Dynamic panel data regressions
are characterized by two sources of persistence over time, namely, autocorrelation due to the
presence of a lagged dependent variable among the regressors and individual effects
characterizing the heterogeneity among the individuals. In this study, the endogeneity problem
associated with dynamic model is dealt with using the generalized method of moments
(GMM) procedure proposed by Arellano and Bond (1991), an efficient procedure as claimed
by Daher et al. (2015).

This study postulates that a dynamic model is able to ascertain the existence of target leverage
on firms in Indonesia. Based on the dynamic partial adjustment model, this study assumes that
a set of explanatory variables commonly cited in the literature, influence the optimal leverage
(Lev*i,t) for a firm as in equation (1).
 Lev*i,t=f(Xi,t)=(NDTSi,t,Profiti,t,Riski,t,Tangibilityi,t,Sizei,t,Growthi,t,Liquidityi,t,Price
Performancei,t) (1)

where i indicates the firms (i=1,….,365) and t indicates the annual time period
(t=2000,….,2011). The observed leverage of firm i at time t (Levi,t) should be equal to the
optimal leverage (Lev*i,t), assuming there is no adjustment cost, that is, Levi,t = Lev*i,t, and this
implies that Levi,t - Levi,t-1 = Lev*i,t - Levi,t-1. However, with the presence of adjustment cost,
the observed leverage of firm i at time t (Levi,t) is no longer equal to the optimal leverage
(Lev*i,t), that is, Levi,t ≠ Lev*i,t. Due to the presence of adjustment costs, firms make only
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partial adjustment. With the partial adjustment, as in this study, δ is expected to be less than 1,
represented in equation (2).

Levi,t - Levi,t-1=δ(Lev*i,t -Levi,t-1) (2)

where δ is known as the speed of adjustment parameter reflecting the gap between a firm’s
desired leverage adjustment and its actual leverage adjustment with 0 < δ ≤ 1. It is to note here
that the speed of adjustment parameter does not vary across firms and over time (see for
examples, Zhengwei, 2013; Daher et al., 2015) with common adjustment speed estimated for
all firms (Ameer, 2010). The firm’s behaviour is represented by equation (3) below.

N
Lev*i ,t = ∑ β k X k ,i ,t + ε i ,t (3)
n =1

Combining equations (2) and (3), the following are derived,

Levi ,t = Levi ,t −1 + δ ( Lev*i ,t − Levi ,t−1 ) (4)

Levi ,t = Levi ,t −1 + δ ( Levi*,t − δ i ,t Levi ,t −1 ) (5)

N
Levi ,t = ( 1 − δ )Levi ,t −1 + δ ( ∑ β k X k ,i ,t + ε i ,t ) (6)
n=1

N
Levi ,t = ( 1 − δ )Levi ,t −1 + ∑ δ β k X k ,i ,t + δε i ,t (7)
n =1
 To simplify, equation (7) can also be written as,
N
Levi ,t = λ0 Levi ,t −1 + ∑ λk X k ,i ,t + µ i ,t (8)
n =1

where λ0=1-δ, λk=δβk, and δεi,t =µi,t (where µi,t has the same properties as εi,t).

This study takes the first difference of equation (8), as proposed by Arellano and Bond (1991),
to eliminate the firm’s fixed effects and thereby avoiding any correlation between unobserved
firm specific effects and the explanatory variables.
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N
∆Levi ,t = λ0 ∆Levi ,t −1 + ∑ λk ∆X k ,i ,t + ∆µi ,t (9)
n =1

Equation (9) denotes the dynamic capital structure model and is estimated based on the
generalized method of moments (GMM) estimator developed by Arellano and Bond (1991)
(which is the GMM First Difference). As one of the advantages of GMM is that, it can handle
important modeling concerns, namely the fixed effects and endogeneity of regressors, whilst
avoiding dynamic panel bias (Daher et al., 2015). It is important to note that the flexible
GMM framework accommodates unbalanced panels, a characteristic of micro panel data set in
this study, as well as endogenous variables (Ramjee and Gwatidzo, 2012; Daher et al., 2015).
This study observes, in the econometrics literature that, varying econometric procedures could
be used to estimate equation (9) ranging from Pooled OLS to fixed effects and random effects,
from Instrumental Variables to GMM. Antoniou et al. (2008), Deesomsak et al. (2009) and
Lemma and Legash (2014) demonstrate that GMM is the most appropriate method to estimate
equation (9) while fixed effects or random effects model may produce bias and inconsistent
estimates (Ramjee and Gwatidzo, 2012). Hence, this study uses GMM for the purpose of
estimation.

The speed of adjustment of firms to target leverage is estimated from equation (9), that is, δ
=1-λ0. This study estimates equation (9) based on the robust t-statistics with standard errors
corrected for heteroskedasticity. To ensure the efficiency of the GMM estimator, this study
performs three diagnostic tests which are the Wald test, used to assess the joint significance of
the determinants of leverage (null: all coefficients on the determinants of leverage are jointly
equal zero); the AR(2) or second order autocorrelation test (null: no second order
autocorrelation in the residuals) and the J-test, a test for the validity of the instrumental
 variables representing Levi,t-1 (null: instrumental variables are valid). Arellano and Bond
(1991) argue that estimates derived from the GMM are only consistent if there is no second
order autocorrelation in the residuals and instrumental variables representing Levi,t-1 are valid.

4. Analysis and Findings

4.1 Descriptive Statistics

Table III summarizes the descriptive statistics of all variables in this study. Indonesian firms
employ a mean leverage of 0.2720 in its capital structure, ranging from 0 to 0.9080.
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Bunkanwanicha et al. (2008) however record a higher leverage of 0.3104 (pre-crisis period of
1992-1996) and 0.5787 (crisis period of 1997/1998) in their studies of 180 Indonesian firms.
Profitability shows a mean of 0.0748 ranging from -0.8807 and 0.8647. Business risk on firms
as represented by yearly change in firms’ EBIT is found to be substantial, shown by the
standard deviation of 0.3981, bigger than the mean of 0.0480. NDTS, tangibility, firm size,
growth, liquidity and share price performance record means of 0.0370, 0.3762, 20.5889,
2.0772, 2.0515 and 0.2902 respectively.

Insert Table III

Table IV details the means of the variables of 365 non-financial firms according to sectors,
classified as according to the ten sectorial classifications by the Indonesian Stock Exchange
(Source: http://www.idx.co.id). Industrial products constituted the biggest sectoral listing
(23.01 percent, 84 firms) followed by consumer products (14.79 percent, 54 firms) while
telecommunication constituted the smallest (1.92 percent, 7 firms). Firms in the construction
sector consumed the highest leverage in their capital structure (mean = 0.3457) while
Information and Technology (IT) the lowest (mean = 0.2149). Consumer products employed
the highest non-debt (mean = 0.0509) while IT the lowest (mean = 0.0090). Property firms
recorded the highest profitability (mean = 0.0992) compared to other sectors while trading and
services experienced the highest volatility in earnings (mean = 0.1010) during the period
understudy. Construction firms recorded the highest asset tangibility (mean = 0.4764) and
firm size (mean = 21.3991) while IT the lowest in term of asset tangibility (mean = 0.2817)
and telecommunication firms in firm size (mean = 19.5044). As for liquidity, firms in the IT
sector are the most liquid (mean = 3.1578). Firms in the IT sector recorded the highest share
price performance (mean = 0.4605) in contrast to the lowest by telecommunication sector
 (mean = 0.1446). This partly explains why telecommunication is the only sector recorded
negative profit (mean = -0.0240) during the period under study. Analysis of Variance
(ANOVA) F-test is performed to test the equality of means of variables between sectors and
results show significant difference in means of each variable between sectors (p=0.01 for all
variables; p=0.05 for share price performance) with exception on growth.

Insert Table IV.

4.2 Correlation
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Table V shows the Pearson correlation coefficients between the independent variables. The
highest correlation between the variables is between profitability and NDTS (r=0.3695,
p=0.01) while profitability is negatively correlated to tangibility (r=-0.0514, p=0.05). Firm
size is positively correlated with profitability, as expected (r=0.1262, p=0.01). Since all the
correlation coefficients are low, which is less than 0.95, the collinearity between the variables
is not a concern as suggested by Gujarati and Porter (2009, p. 340), Hence, all the
independent variables are included in the regression model.

Insert Table V

4.3 Existence of Target and Speed of Adjustment to Target Capital Structure

Table VI presents the empirical results on the determinants of target leverage of Indonesian
firms. The estimated coefficient of the lagged leverage is significant (p=0.01) thus indicates
the practice and pursuance of target capital structure among all firms understudy during the
2000-2011 period. The pursuance of target capital structure by these firms as detected in this
study thus confirms the survey finding by Baker and Powell (2009) that managers of listed
firms in Indonesia have desire to maintain a target leverage. With the existence of target
leverage, these firms occasionally rebalance to long term target leverage at the speed of
0.6274 (δ =1-λ0) within a year or it takes 1.594 year (1/δ) to be at the target. This concludes
that these firms close by 62.74% the gap between current and target leverage within one year.
A significant coefficient of 0.6274 (p=0.01) for the adjustment speed parameter (δ) supports
our argument that the speed of adjustment is important in explaining capital structure
adjustment process. In relation to this study, Tzang et al. (2013) in their study on Indonesian
manufacturing and non-manufacturing firms for the period between 1992 and 2010, find that
 all firms generally adjust at the rate of 0.6177 to their target once deviated while Ameer
(2010), in his cross countries study over the period of 1991-2004, documents Indonesian firms
adjusting to target at the rate of 0.6192. Such a rapid adjustment towards the target leverage
recorded in this study suggests the applicability of dynamic TOT on capital structure decision
of Indonesian firms (Flannery and Rangan, 2006; Haron et al., 2013b). Dynamic TOT
explains that being at the target will allow firms to generate substantially more net cash flow
thus be able to engage with new profitable investment opportunities and eventually maximizes
the firms’ value. Whereas firms failing to be at the target will suffer from lower risk-adjusted
return and not be able to sustain profitable operations (Chung et al., 2013). Realising the
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implication and benefit of being at the target leverage is substantially higher than being off the
target, firms in Indonesia thus rebalance instantaneously.

Insert Table VI

4.4 Determinants of Leverage

Five determinants (profitability, business risk, firm size, liquidity and share price
performance) are found to significantly influence the target leverage of Indonesian firms
throughout the period understudy. This study depicts a negative relationship between
profitability and leverage (p=0.01), H2 is thus supported. The negative relationship indicates
the practice of hierarchical financing (POT) where firms with high profit consume less debt
financing in their capital structure. This finding is similar with past studies on Indonesian
firms (Bunkanwanicha et al., 2008; De Jong et al., 2008; Ameer, 2010; Moosa and Li, 2012).
This may be resulted from the new reformation of the financing policy in 1988 where firms
have choice to use their retained earnings to finance their investments (Moosa and Li, 2012).

Business risk is reported to relate negatively to target leverage (p=0.01), H3 is thus supported.
The descriptive statistic of this study also suggests that firms with the highest business risk
employed among the lowest leverage in their capital structure (refer Table IV). This finding is
similar to De Jong et al. (2008) and Ameer (2010) and confirms the TOT indicating that
Indonesian firms with volatile earnings employed lower debt in their capital structure. This
finding can perhaps be explained by the cautious lending policies practiced by the Indonesian
government and banks resulting from the 1997/1998 crisis as highlighted by Tambunan
(2010), thus firms with higher business risk could only engage to a much lower debt level in
their capital structure.
 A significant negative relationship (p=0.01) between firm size and leverage is observed,
similar to Bunkanwanicha et al. (2008). However, this finding does not support De Jong et al.
(2008) and Ameer (2010) in their cross countries study that also include Indonesian firms. The
negative relationship is in contrast to H5 where a positive relationship is expected. This study
argues that as large firms have less asymmetric information problem, they can issue equity
easily, thus reducing debt. This finding supports POT as size is an inverse proxy for the
degree of asymmetric information between firms and investors. Information asymmetries are
less severe for large firms than for small ones (Moosa and Li, 2012). Looking at Indonesian’s
financial market reformation scenario, when control over initial offering prices and the daily
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movement of stock prices were lifted, it has driven large firms to issue equity over debt, thus
explains the negative relationship between size of firm and leverage recorded in this study.

Liquidity is found to relate negatively with leverage of firms in Indonesia (p=0.01), similar to
Deesomsak et al., 2009 and Moosa and Li, 2012. H7 is thus supported. Deesomsak et al.
(2009) argue that liquid assets may be used as source of financing and firms in Indonesia
seem to consider these liquid assets in deciding their capital structure. A negative relationship
between leverage and liquidity of Indonesian firms implies that firms finance their activities
following the financing hierarchy of the POT (Moosa and Li, 2012). This reinforces the
negative relationship evidenced earlier between both profitability (H2) and firm size (H5) with
leverage.

These three negative relationships with leverage (profitability, firm size and liquidity) depict a
high and significant influence of hierarchical financing of POT in the capital structure of
Indonesian firms. The influence of POT depicted in this study confirms the recent analysis by
IMF, conducted by Felman et al. (2011) on ASEAN5. They realise that as part of the post-
Asian crisis changes, firms in the region such as Indonesia struggled to increase their
profitability, and succeeded in doing so. They were consequently able to fund a much larger
portion of their diminished investment needs from their own internal cash generation. The
World Bank 2010 reports that Indonesia’s economy managed to bounce back on track a year
after the financial crisis with economic activity picking up, inflation remains moderate and the
financial market rises. The government shows strong supports and is all up for a new, rebuilt
Indonesia, making Indonesia well positioned for further acceleration and more inclusive
growth.
 The traces of POT influence detected in this study imply that Indonesian firms understudy
vigorously look for financing instruments that will minimize the cost of capital, such as
banking and private bond market. Any choice of financing mix that leads to the lowest
weighted cost of capital is considered as the target capital structure. The hierarchical concept
of POT determines that as long as it is not constrained by debt capacity, a firm will always
cover its external financing needs with debt when retained earnings is exhausted, thereby
enhancing return to shareholders. Nevertheless, looking at the debt financing instruments in
Indonesia, between banking and private bond market, Burger et al. (2015) record that, as at
the end of 2011, local corporate bond market has a very limited capacity to serve as an
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intermediary for debt financing due to its mere size and illiquidity (1.4 percent of GDP) in
comparison to banking (32 percent of GDP). The Indonesian finance sector hence is not a
diversified one following huge imbalance between the two important components, banking
and private bond market.

Share price performance is found to affect leverage negatively (p=0.01), H8 is thus supported.
The finding is similar with Setyawan and Budi (2012). This finding supports the market
timing hypothesis and indicates that when firms equity record good performance, equity
capital will be preferred by Indonesian firms. Equally, in a declining stock market, the debt
ratio of firms increases. This is also perhaps the results of the fair game after the new
reformation of financing policy in 1988 where the state-owned banks no longer monopolize
financing sources leaving managers to also look at equity issuance as source of financing
following the establishment of Indonesian equity market in 1989. Equity market development
promote firm’s equity financing thus can encourage equity issuance as the financing choices
of firms (Ameer, 2010). This is evidenced from the number of IPO issuance in the Indonesian
Stock Exchange in which the number nearly doubled from 13 in 2009 to 25 in 2012, raising a
total of US$ 1 billion (Source: http://www.idx.co.id).

Nonetheless results of this study show that some of the determinants appeared to be
insignificant despites being reported as important factors in past studies when examined using
the static model. Based on the dynamic model employed, this study finds insufficient evidence
to conclude on the influences of NDTS, tangibility and growth on capital structure. This
conflicting result between the dynamic and static model provides evidence thus supports
Haron (2014a) where he claims that the contrasting nature of the static and the dynamic may
influence the results of the findings.
 5. Conclusion

This study investigates the dynamic aspects of capital structure particularly on the existence of
target capital structure, the speed of adjustment and the factors influencing target capital
structure of Indonesian firms. This study finds that Indonesian firms do practice target capital
structure and the capital structure decision is influenced by firm specific factors like
profitability, business risk, firm size, liquidity and share price performance due to time
varying factors. Pursuing target capital structure and identifying the influencing factors may
gear the firm to value maximization thus is indeed a paramount move for a firm to ensure
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sustainability and competitiveness and firms in Indonesia demonstrate that in this study.

The magnitude of speed of adjustment recorded in this study suggests a rapid adjustment
towards target leverage thus supporting the existence of dynamic TOT in the capital structure
decisions of firms in Indonesia. POT appears to also have significant influence in the capital
structure decisions in Indonesia, particularly after the new reformation of financing policy,
where retained earnings is also preferred as source of financing apart from merely external
financing through bank loans. This finding indicates that firms in Indonesia opt to the
cheapest financing mode which is the internal funding perhaps due to the effects of the
collapse of banking sectors during the 1997/1998 financial crisis. Therefore, by identifying
and taking into account the affecting factors to target capital structure, managers will have a
comprehensive guide in maximizing the value of the firm so wealth can be distributed well
among shareholders and the firm can prosper even more.

There are also traces of market timing influences where firms also seem to time their equity
issuance. By employing a robust econometric model (GMM), this study contributes to the
literature by extending the existing literature on Indonesia and examining the corporate
financing behaviour and speed of adjustment based on a more realistic assumption where
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.

This study draws important practical and policy implications for corporate finance. 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. TOT deals with the benefit and cost
of debt while POT emphasizes on the issuance of debt as second option after internal
 financing is exhausted to support growth. The financial sector reformation does have a
positive impact on the banking sector with the banking system constitutes 32 percent of GDP
– end 2011. The big contribution of banking sector to GDP indicates the acceleration of debt
financing to firms. Nevertheless, the local corporate bond market does not seem to follow
similar track, with merely 1.4 percent of GDP – end 2011, implying lacking in size and
liquidity. Therefore, regulator and policy makers 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 among firms in Indonesia, as bond market represents an
important component of a diversified financial sector. All these findings and implications
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drawn from this study may assist firm managers to exert their influence on firm characteristics
as well as the capital structure adjustment speed and hence optimizes cost of capital and
ultimately achieves good firm value.

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.

Note
1. Intangible asset is not included in this study as intangible asset is not easily identifiable,
separated and utilized, making it susceptible to informational asymmetry. Furthermore,
their value is more sensitive to who owns and employs them. These features make many
intangible assets poor collateral and their redeploy ability limits firms to finance intangible
asset with debt, making it less popular (Balakrishnan and Fox, 1993). In addition, Frank
and Goyal (2009) state that intangible asset is more difficult for outsiders to value.

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 Table I. Explanatory variables, measurement, hypothesis and expected signs

Explanatory Variables Measurement Hypothesis Predicted sign

Annual depreciation expenses/
Non-Debt Tax Shield H1 -
Total Asset
Profitability EBIT/Total Asset H2 -
Business Risk Yearly change in firm EBIT H3 -
Tangibility Net Fixed Asset/Total Asset H4 +
Firm Size Log Total Asset H5 +
Market Value Equity/Book Value
Growth H6 -
Equity
Liquidity Current Asset/Current Liabilities H7 -
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Share Price Yearly change in year-end share

H8 -
Performance price

Table II. Structure of panel data

Year listed No. of years listing to No. of records on No. of observations
2011 each firm
2009 3 18 54
2008 4 27 108
2007 5 33 165
2006 6 14 84
2005 7 10 70
2004 8 19 152
2003 9 4 36
2002 10 7 70
2001 11 7 77
2000 12 226 2712
Total 365 3528
Source: Datastream
 Table III. Descriptive statistics (whole sample)
Variable N Mean Maximum Minimum Standard Deviation
Leverage 3528 0.2720 0.9080 0.0000 0.2241
NDTS 3528 0.0370 0.2730 0.0000 0.0302
Profitability 3528 0.0748 0.8647 -0.8807 0.1435
Business Risk 3528 0.0480 0.8823 -0.7659 0.3981
Tangibility 3528 0.3762 0.8852 0.0000 0.2335
Firm Size 3528 20.5889 25.9180 13.2249 1.7660
Growth 3528 2.0772 58.3900 -7.6800 4.5490
Liquidity 3528 2.0515 12.8000 0.2000 1.7689
Share Price Performance 3528 0.2902 4.8125 -0.8000 0.8421
Notes: N = Number of observations; Number of all firms = 365
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Source: Author’s own computation

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Table IV. Descriptive statistics (sectoral)

Sector
Real Trading Information Infrastructure,
Industrial Consumer ANOVA
Estate/ Plantation and Mining Construction and Utilities and Telecommunication
Products Products F-test
Properties Services Technology Transportation
Variable
Leverage 0.2816 0.3010 0.2209 0.2830 0.2224 0.2600 0.3457 0.2149 0.3297 0.2792 10.3674***
NDTS 0.0402 0.0509 0.0220 0.0331 0.0428 0.0483 0.0388 0.0090 0.0338 0.0272 51.3281***
Profitability 0.0612 0.0611 0.0992 0.0900 0.0861 0.0980 0.0726 0.0444 0.0793 -0.0240 8.0679***
Risk 0.0291 0.0281 0.0605 0.0852 0.1010 0.0384 0.0079 0.0877 0.0154 0.0293 4.3479***
Tangibility 0.3776 0.4555 0.3339 0.4502 0.3154 0.2894 0.4764 0.2817 0.3616 0.3334 26.7580***
Firm Size 20.5096 20.6459 20.6192 20.6503 19.9591 20.8526 21.3991 20.9268 20.2963 19.5044 13.9228***
Growth 1.7692 1.8651 2.9313 2.4504 2.3462 2.5646 1.4071 1.8781 1.1584 2.3356 1.1495
Liquidity 1.9816 1.6576 2.3378 1.9667 2.3405 2.2777 1.5809 3.1578 2.2196 2.0269 9.0609***
Share Price
0.2428 0.2365 0.3047 0.4420 0.2879 0.2881 0.2672 0.4605 0.2227 0.1446 2.4679**
Performance
No. of
84 54 44 41 37 32 28 19 19 7
Firms
% of Firms
to Total
23.01 14.79 12.05 11.23 10.14 8.77 7.67 5.21 5.21 1.92
Sample
N=365
Notes: Sector classification is following the sectorial listing of the Indonesian Stock Exchange (Source: http://www.idx.co.id/); ANOVA F-test is performed to test the
equality of means of variables between sectors; ***, **, * denotes the significant of F-statistic at 0.01, 0.05 and 0.10 levels respectively
Source: Author’s own computation
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Table V. Pearson correlations

Independent NDTS Profitability Business Risk Tangibility Firm Size Growth Liquidity Share Price
Variables Performance
NDTS 1
Profitability 0.3695*** 1
Business Risk -0.0359 0.0015 1
Tangibility 0.2233*** -0.0514** -0.0400** 1
Firm Size -0.0838*** 0.1262*** -0.0037 02475*** 1
Growth -0.0199 0.0129 -0.0294 0.0438** 0.0592*** 1
Liquidity -0.0589*** 0.0115 0.0469** -0.1540*** -0.1338*** -0.0039 1
Share Price
-0.0315 0.0093 0.0574*** 0.0071 0.0319 0.0622*** 0.0237 1
Performance
Notes: ***Correlation is significant at the 0.01 level (two-tailed); **Correlation is significant at the 0.05 level (two-tailed)
 Table VI. Speed of adjustment and determinants of target leverage
Leverage
Independent Variable VIF
(TD/TA)
0.3726***
Leverage(-1) λ0
[14.1650]
0.6761
NDTS 1.2350
[1.5806]
-0.3750***
Profitability 1.1496
[-79.8623]
-0.0049***
Business Risk 1.0012
[-4.8213]
0.1071
Tangibility 1.1149
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[1.0353]
-0.1107***
Firm Size 1.0809
[-7.0240]
0.0000
Growth 1.0069
[0.5772]
-0.0261***
Liquidity 1.0129
[-29.9851]
-0.0114***
Share Price Performance 1.0028
[-3.8971]
AR(1) -2.0631**
AR(2) -1.3346
Wald (joint) χ2 820088.1***
J-statistic 69.6494
No. of Observations 3528
∆Levi,t = ∆Lev(-1)i,t +β1∆NDTSi,t +β2∆TANGi,t +β3∆PROFITi,t + β4∆RISKi,t+ β5∆SIZEi,t+ β6∆GROWTHi,t+
β7∆LIQUIDITYi,t +β8∆SPPi,t+εi,t.
Notes: The t-statistics in parentheses are the t-values adjusted for White’s heteroscedasticity consistent standard
errors; ***, **, * denotes significant at 0.01, 0.05 and 0.10 levels respectively. The Wald test statistic refers to
the null: all coefficients on the determinants of leverage are jointly equal zero; AR(2) or second order
autocorrelation test refers to the null: no second order correlation in the residuals; the J-test statistic refers to the
null: instrumental variables are valid. Multicollinearity test in the dataset is performed and no multicollinearity
problem is found in the data since the variance inflation factor (VIF) of variables are less than 10
 Razali Haron is an Associate Professor at the IIUM Institute of Islamic Banking and Finance,
International Islamic University, Kuala Lumpur, Malaysia and a Research Fellow for the Centre
for Islamic Economics, International Islamic University, Kuala Lumpur, Malaysia.
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