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Capital structure
A note on capital structure target
target adjustment –
Indonesian evidence
245
Ludwig Reinhard
University of South Austrailia and Roedl & Partner-Worldwide Dynamics,
Rhineland-Palatinate, Germany
Steven Li
University of South Australia, Adelaide, Australia

Abstract
Purpose – The purpose of this paper is to investigate whether existing capital structure target
adjustment models are able to identify whether companies adjust their capital structures towards an
(unobservable) target.
Design/methodology/approach – Existing capital structure target adjustment models are applied
to a specific dataset by using different regression techniques (ordinary least square, fixed effect,
Fama-MacBeth, least square dummy variable “corrected”, SYS-GMM).
Findings – Existing capital structure target adjustment models are not able to identify whether
companies adjust their capital structures towards a target or not. They might indeed indicate target
adjustment behaviour when companies’ capital structures actually move away from their targets.
Research limitations/implications – As target adjustment behaviour is often used as support for
the trade-off and against the pecking order theory, the “horse race” between both theories seems still to
be open.
Originality/value – This paper highlights some of the fallacies of existing capital structure target
adjustment models and demonstrates that the results obtained by those models can be highly
misleading.
Keywords Capital structure, Targets, Indonesia
Paper type Research paper

1. Introduction
According to the capital structure trade-off theory, companies have an optimal or
target[1] capital structure, which is determined by the trade-off between the
advantages and disadvantages of debt financing (Altman, 1984, Scott, 1976). Dynamic
versions of the trade-off theory claim that companies would undo the effects that
random shocks have on their capital structures by actively re-adjusting them towards
their target levels. Supported by the results of management surveys (Bancel and
Mittoo, 2004; Brounen et al., 2004, Graham and Harvey, 2001), numerous studies
empirically analyse how long it takes until companies are adjusting their capital
structures towards their desired capital structure target levels (Antoniou et al., 2008,
Fama and French, 2002, Flannery and Rangan, 2006). Depending on the regression International Journal of Managerial
model and technique used, those studies typically find that companies adjust their Finance
Vol. 6 No. 3, 2010
capital structures with a “speed” of around 10-30 per cent per year towards their capital pp. 245-259
q Emerald Group Publishing Limited
1743-9132
The authors are grateful to an anonymous referee for some useful suggestions. DOI 10.1108/17439131011056242
IJMF structure targets[2]. Recently, D’Mello and Farhat (2008) carried target adjustment
6,3 studies to the extremes by claiming that a company’s moving average debt ratio would
be the “best” available proxy for a company’s optimal capital structure.
Encouraged by the study of D’Mello and Farhat (2008), we analyse whether or not
capital structure target adjustment studies commonly found in the literature are able to
identify whether companies adjust their capital structures towards an (unobservable)
246 target or not. In other words, we try to identify whether capital structure target
adjustment studies “mean what they say”.
By replicating the results of prior capital structure target adjustment studies, this
paper finds some evidence that commonly used capital structure target adjustment
models are not able to identify whether companies adjust their capital structures
towards a certain target or not. In fact, our results show that obtained capital structure
target adjustment measures might be highly misleading and indicate a target
adjustment when companies actually move away from their capital structure targets.
The main contribution of this paper is that it highlights some of the weaknesses of
capital structure target adjustment studies and their results, which are commonly used
as support for the trade-off and against the pecking order theory. The identified
weaknesses of capital structure target adjustment models have important implications
for tests of the different capital structure theories, especially for tests of the trade-off
and pecking order theory. Based on the identified weaknesses of capital structure
target adjustment studies and the results obtained in this paper, it appears that
existing capital structure studies are not able to differentiate between the trade off and
the pecking order theory. The “horse race” between the two major capital structure
theories (trade-off and pecking order theory) seems thus still to be open.
The remainder of this paper is organised as follows. The next section briefly
reviews important capital structure target adjustment studies. This section is followed
by a description of the data and regression techniques used to identify corporate target
adjustment behaviour before the results are analysed.

2. Literature review
In line with the implications of the trade-off theory, management surveys that analyse
the financing decisions of companies in the USA and Europe find empirical evidence
for the notion that companies have capital structure targets that influence their
financing decisions (Bancel and Mittoo, 2004; Brounen et al., 2004; Graham and Harvey,
2001). Based on those survey results, several studies try to identify how fast companies
are adjusting their capital structures towards their (unobservable) capital structure
targets.
A first and often cited study in this context is from Fama and French (2002), which
analyses the financing decisions of US companies over the years from 1965-1999 and
finds that companies adjust their capital structures at a rate of 7-18 per cent per year
depending on whether a company pays dividends or not. Even though Leary and
Roberts (2005) do not primarily focus on how fast companies adjust their capital
structures towards their desired target level, they provide some evidence for the notion
that companies actively rebalance their capital structures, which they interpret as
being consistent with the existence of a “target range of leverage” (Leary and Roberts,
2005, p. 2577). Flannery and Rangan (2006) on the other hand, explicitly analyse the
adjustment speeds of their US sample companies over the years from 1965-2001 and Capital structure
find that companies adjust their capital structures rather quickly towards their target target
levels in approximately three years. By using similar regression techniques, Drobetz
and Wanzenried (2006) and DeHaas and Peeters (2006) document comparable results
for companies from Central and Eastern Europe. Finally, Antoniou et al. (2008), who
analyse the financing decisions of companies from the USA, UK, Germany, France and
Japan over the years from 1987 to 2000 find also some support for the consideration 247
that companies adjust their capital structures towards target levels.
All of the results of the different target adjustment studies analysed so far appear to
be in line with a dynamic capital structure trade-off model, according to which
companies would undo the effects of random events that bump their capital structures
away from their target ratios by actively re-adjusting them towards their target levels.
Yet, in contrast to those capital structure target adjustment studies, Welch (2004)
and Lemmon et al. (2008) show that companies are not doing much to offset the effects
of random “shocks” to their capital structures. This outcome seems to be perplexing, as
the different studies that analyse the financing decisions of companies in the US use
almost identical datasets.
Given these conflicting outcomes, this study aims to answer the question whether
the different capital structure target adjustment studies are indeed able to identify
whether companies adjust their capital structures towards a target. To this end, we
decided to focus our analysis on a dataset that would easily, i.e. without further
statistical analysis, allow us identifying whether companies adjust their capital
structures towards a certain target or not. We consequently decided to analyse the
corporate financing decisions of companies from Indonesia over the years from
1995-2007.
Unfortunately, there is no single indicator available that would provide us with the
information whether or not companies were able to adjust their capital structures
towards their target levels. We thus decided to use a number of different indicators that
we believe provide us with an indication whether the Indonesian sample companies
have been able to adjust their capital structures towards their target levels or not.
Those indicators are illustrated in the following Table I.
Table I is separated into two parts. The upper part, denominated as “external
financial sources”, provides some information about important external financial
sources available in Indonesia in general. The lower part, denominated as “internal
financial sources” provides an overview of important internal sources and uses of
funds of the Indonesian sample companies (see below) over the years surrounding the
Asian crisis.
As can be identified from the upper part of Table I (“external financial sources”),
there has been a considerable reduction in funds raised by companies from organised
public (debt and equity) markets from 1998 onwards. A similar decline (with a delay of
one year) can be identified for working capital loans and investment loans from banks,
which both declined dramatically in 1999.
The lower part of Table I shows the mean values of selected financial data from the
financial statements of the sample companies. As can be identified, there has been a
considerable reduction in the number of public debt and equity issues of the sample
companies over the years 1998 and 1999. This reduction seems to have caused the
IJMF
Year 1995 1996 1997 1998 1999 2000
6,3
External financial sources
Number of IPOs 17 19 34 3 12 25
Volume IPOs 5,682 2,662 3,951 68 805 1,772
Bank and finance 16 977 652 0 173 n.a.
248 Others 5,666 1,686 3,299 68 632 n.a.
Number of right issues 10 19 20 10 14 10
Volume of right issues 3,182 1,1924 15,887 5,068 130,682 17,548
Bank and finance 380 3,289 3,188 2,561 127,787 n.a.
Others 2,802 8,636 12,699 2,506 2,895 n.a.
Number of public debt issues 4 5 15 0 6 15
Volume of public debt issues 2,185 2,841 7,205 150 4,284 5,613
Bank and finance 370 91 1,800 0 1,050 518
Others 1,815 2,750 5,405 150 3,234 5,095
Working capital loans 175,337 222,478 240,758 314,208 143,356 163,630
Investment loans 59,274 70,443 100,735 141,464 57,691 65,276
Internal financial sources
Sale of common and preferred stock 46,876 22,349 71,324 13,773 5,145 25,146
LT-debt issuance 132,767 148,750 302,173 155,699 67,947 131,907
Disposal of fixed assets 5,057 9,448 11,645 31,666 4,830 6,272
Net income 76,929 85,620 25,687 46,162 189,709 712
Total sources of funds 319,685 352,308 603,149 495,406 452,257 567,970
LT-debt retirement 40,561 69,136 114,755 117,660 188,413 270,871
Dividend payments 20,415 22,251 30,086 17,179 25,349 67,635
Interest payments 45,236 58,553 117,457 147,270 149,196 172,065
Current assets 538,828 548,330 884,921 849,064 1,071,198 1,205,644
Current liabilities 321,145 348,925 748,258 824,165 957,244 1,450,950
Total common equity 537,276 596,421 683,551 972,881 1,106,816 1,326,415
Total liabilities 704,498 797,815 1,635,180 1,681,970 1,817,466 2,412,558
Total assets 1,279,732 1,434,854 2,364,643 2,675,875 2,966,856 3,790,929
Notes: This table shows selected external and internal financial indicators of the Indonesian economy
in general (“external financial sources”) and of the sample companies analysed (“internal financial
sources”). All volume data in the upper “external financial sources” part are in billion IDR while all
data in the lower “internal financial sources” part are in million IDR. The volume figures in the upper
“external financial sources” part are reported in “total”, for “bank and finance” companies and “other”
Table I. companies to show possible effects resulting from external market changes on corporate financing
Target adjustment decisions
indicators Source: Bank Indonesai

reduction in the total sources of funds available for the sample companies over those
years.
Starting from 1999 onwards, the Indonesian sample companies retired more
long-term debt than they issued. This financial behaviour might be interpreted to be
motivated by target adjustment behaviour. Yet, given the increase in interest payments
due to soaring market interest rates and the overall increase in total liabilities, it
appears that these companies tried to survive the Asian crisis period by restructuring
their debt in a way to use less interest bearing long-term debt and more non-interest
bearing short-term debt, such as trade credit.
 Other indicators that lead us to the conclusion that the Indonesian sample Capital structure
companies have not deliberately adjusted their capital structures towards their target target
levels over the years of the Asian crisis are the increase in the disposal of fixed assets
and the decrease in dividend payments, which seem to be elements of a “survival
tactic” rather than the elements of a deliberate target adjustment strategy.

3. Methodology 249
3.1 Data
Initially all listed companies in Indonesia over the years from 1995 to 2007 were
selected. Thereafter, all financial (SIC codes 6000-6999) and utility companies (SIC
codes 4900-4999) were excluded as their financing decisions might be influenced
by minimum capital requirement regulations or explicit or implicit government
guarantees. To avoid that outliers influence the results, we excluded all
technically insolvent companies, i.e. those with a total liabilities to total asset
ratio of larger than unity. We further required that each company has at least
one year of usable data before (1995-1996), during (1997-2000) and after
(2001-2007) the Asian crisis to avoid that the sample is biased towards young
and newly listed companies with a short history of data that have not directly
been influenced by the Asian crisis. By doing so, we were able to obtain a panel
consisting of 749 firm-year observations.

3.2. Regression model and estimation technique

To identify whether or not target adjustment considerations are behind the capital
structure changes of our Indonesian sample companies, the following capital structure
target adjustment model is set up, which (in its simplest form) can be expressed as
follows[3].
*
ðCSit 2 CSit21 Þ ¼ b0 þ b1*ðCS 2 CSit21 Þ þ 1it : ð1Þ
The capital structure target adjustment model illustrated in equation (1) is identical to
the one commonly used in the literature (see, e.g. D’Mello and Farhat, 2008) and states
that changes in a company’s capital structure (CSit – CSit2 1) are caused by a
company’s desire to adjust its capital structure towards its target level (CSit*).
A first problem, which can be identified from equation (1) is the simultaneity
between a company’s current and target capital structure. That is, according to the
target adjustment model illustrated in Equation (1) companies would adjust their
capital structures towards a target that they would effectively observe only at the end
of the year, i.e. after they already adjusted their capital structures. Most studies simply
ignore this problem, which seems to be justifiable, as DeHaas and Peeters (2006)
demonstrate[4].
The target adjustment model in equation (1) can be rearranged as follows:
*
CSit ¼ b0 þ b1*CS 2 b1*CSit21 þ CSit21 þ 1it ð2Þ
which can be further simplified to:


CSit ¼ b0 þ b1*CS þ 1 2 b1 * CSit21 þ 1it :
*
ð3Þ
IJMF A problem with the regression model illustrated in equation (3) is that it cannot be
6,3 directly estimated, as a company’s target leverage ratio (CSit*) is not directly observable.
To overcome this problem, it is usually assumed that a company’s target capital
structure ratio is itself a function of other variables (“Xjit”)[5] that have been found to
influence a company’s capital structure decisions, i.e.:

250 *
X
k
CS ¼ aj*Xjit ð4Þ
j¼1

By inserting equation (4) into equation (3), the following testable model results:

 X
k
CSit ¼ b0 þ 1 2 b1 * CSit21 þ b1* aj*Xjit þ 1it ð5Þ
j¼1

The main interest in this target adjustment model is the regression estimator (1 2 b1),
which is assumed to provide an indication about a company’s capital structure target
adjustment speed.
Several authors estimate regression models similar to the one illustrated in equation
(5) either by OLS or Fama-Mac Beth regressions[6] and consequently obtain biased
regression results[7]. To overcome problems resulting from the inclusion of lagged
dependent variables, researchers increasingly use corrected least square dummy
variable (LSDVC) or GMM regression models, which are especially designed for
regression models with lagged dependent variables (Arellano and Bond, 1991; Arellano
and Bover, 1995; Blundell and Bond, 1998; Bond, 2002; Bruno, 2004, 2005; Bun and
Kiviet, 2003; Kiviet, 1999; Windmeijer, 2005).
By using Monte Carlo simulations, several studies show that the LSDVC regression
estimators outperform GMM regression estimators especially in panels with a small
number of cross-sectional observations (Bruno, 2004; Buddelmeyer et al., 2008; Judson
and Owen, 1999). However, both, the LSDVC and the GMM regression techniques have
their weaknesses[8]. We consequently report both results below together with the often
used Fama-MacBeth regression results. In addition to those results, OLS and fixed
effect regression results are reported based on the consideration that OLS regression
estimators are biased upwards while fixed effect regression estimators are biased
downwards and that the “true”, i.e. unbiased regression estimators are likely to lie in
between both estimators (Arellano and Bond, 1991; Bond, 2002).

4. Results
Table II reports the regression results for the capital structure target adjustment model
illustrated in equation (5)[9].
In line with prior capital structure target adjustment studies, we use a company’s
long-term debt to total asset ratio as the dependent variable and use the tangibility of a
company’s assets (TAN), its size (SIZE), its profitability (PROFIT) and its growth
(GROWTH) as the independent variables[10] (DeHaas and Peeters, 2006; Drobetz and
Wanzenried, 2006; Flannery and Hankins, 2007; Flannery and Rangan, 2006) and
control for industry effects.
 OLS FE FM LSDVC GMM-SYS
1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005

LT-Debt/TA [t2 1] 0.57*** 0.62*** 0.02 0.34*** 0.57*** 0.63*** 0.40*** 0.68*** 0.54*** 0.64***
(9.65) (20.73) (0.28) (8.21) (12.10) (13.78) (4.50) (9.93) (4.05) (12.75)
TAN 0.12** 0.10*** 0.08 0.09 0.10 0.10** 0.25* 0.01 0.16 0.02
(2.40) (3.27) (0.76) (1.13) (1.48) (3.84) (1.86) (0.15) (1.32) (0.24)
SIZE 0.01** 0.02*** 20.01 0.02 0.02 0.02** 2 0.01 0.05 20.00 0.02
(2.25) (3.86) (20.40) (1.00) (1.73) (2.82) (2 0.31) (1.62) (20.02) (1.40)
PROFIT 2 0.01 2 0.14*** 0.04 2 0.17*** 0.03 20.07 0.21 20.09 0.14 2 0.23*
(2 0.12) (2 3.15) (0.41) (2 3.58) (0.32) (21.36) (1.47) (20.68) (1.13) (2 1.79)
GROWTH 2 0.02* 2 0.01 20.01 2 0.03* 20.03* 20.02* 2 0.01 0.01 20.03 2 0.00
(2 1.71) (2 1.50) (20.47) (2 1.70) (23.00) (22.16) (2 0.50) (0.50) (21.56) (2 0.06)
CONST 2 0.08 2 0.24*** 0.31 2 0.22 0.03 20.13 n.a. n.a. 0.03 2 0.20
(2 0.66) (2 3.25) (0.89) (2 0.68) (0.12) (21.03) n.a. n.a. (0.12) (2 1.27)
R2 0.44 0.68 0.01 0.62 0.51 0.72 n.a. n.a. n.a. n.a.
F 20.46 74.08 0.20 18.83 5.67 6.32 n.a. n.a. 8.23 71.45
p 0.00 0.00 0.96 0.00 0.09 0.04 n.a. n.a. 0.00 0.00
IAS 2.32 2.67 1.02 1.51 2.33 2.69 1.67 3.08 2.18 2.81
Notes: * denote significant levels at the 10 per cent level; ** denote significant levels at the 5 per cent level; *** denote significant levels at the 1 per cent
level; this table shows the regression results for the capital structure target adjustment model illustrated in Equation (5). OLS ¼ ordinary least square
regressions, FE ¼ fixed effect regressions, FM ¼ Fama-MacBeth regressions, LSDVC ¼ least square dummy variable “corrected” regressions, GMM-
SYS ¼ two-step system GMM regression results. Fama-MacBeth regression results are obtained by using the user-written Stata command “xtfmb” from
Daniel Hoechle. LSDVC results are obtained by using the user-written Stata command “xtlsdvc” from Giovanni S.F. Bruno. The GMM-SYS results are
obtained by using the user-writen Stata command “xtabond2” from David Roodman (2006). The implied adjustment speed (IAS) in years is calculated by
the inverse difference of unity and the LT-Debt/TA[t2 1] estimator. T-statistics are in parentheses
Capital structure

variable: LT-Debt/TA
adjustment – dependent
Regression results target
target

251

Table II.
IJMF Even though the regression estimators for the other control variables included in the
6,3 regression model are not directly comparable with those of other capital structure
studies[11], they appear to be in line with the findings in previous studies. That is,
larger companies, those with lower growth opportunities and companies with lower
profits borrow in general more than other companies.
In respect to the target adjustment regression estimators, the results reported in
252 Table II show in general a statistically significant positive regression result for the
“LT-Debt/TA[t2 1]” variable. Antoniou et al. (2008, p. 75) interpret this result as follows:
“The statistically significant coefficient of the lagged dependent variable confirms that
firms have a target capital structure and on average do not fully adjust to the target
every year . . . ”.
Furthermore, the smaller implied adjustment speed parameters (IAS) during the
years of the Asian crisis indicate that the Indonesian sample companies adjusted their
capital structures relatively faster towards their target levels than after the Asian crisis
period[12], which seems to be in contrast with the previous consideration that these
companies have not been able to adjust their capital structures towards their target
levels during the years of the Asian crisis due to the shortage of internal and external
funds.
To investigate this issue further, we performed a graphical analysis of the capital
structure decisions of the Indonesian sample companies (see Figures 1 and 2). We use
this graphical analysis as additional support for our hypothesis that the Indonesian
sample companies have not been able to adjust their capital structures towards their
target levels during the years of the Asian crisis.

Figure 1.
Capital structure measures
 Capital structure
target

253

Figure 2.
Gap capital structure to
target measures

Figure 1 shows the development of the capital structure ratios (LT-Debt/TA) of the
Indonesian sample companies together with their average (Average LT-Debt/TA) and
moving average (MA LT-Debt/TA) capital structure measures[13] over the years from
1997 to 2005. Figure 2 on the other hand shows the absolute difference (“gap”) between
the actual capital structure measures of the sample companies (“Act”) and the two
target measures (“Avg” and “MAvg”).
As can be identified from Figure 2, the gap between the actual capital structure
measures of the Indonesian sample companies (LT-Debt/TA) and their capital
structure target measures (Average LT-Debt/TA and MA Debt-TA/TA) increased
during the years of the Asian crisis especially from 1999 onwards. This increasing gap
indicates that the sample companies’ capital structures moved away from their targets
during those years. Starting from 2001 onwards, the gap between the actual and target
capital structure measures declined, indicating that the capital structures of the
Indonesian sample companies approached their target measures.
The graphically identified target adjustment behaviour implies a relatively faster
target adjustment speed during the years after the Asian crisis than during the Asian
crisis years. Yet, the implied adjustment speed measures (IAS) in Table II indicate the
opposite. That is, they show a relatively faster target adjustment during the years of
the Asian crisis than thereafter.
Given these contradicting results, it appears that existing capital structure target
adjustment models can be misleading and indicate target adjustment behaviour when
companies actually move away from the targets. In other words, existing capital
structure target adjustment models do not appear to be able to identify whether
companies adjust their capital structures towards a certain target or not. They rather
IJMF simply document a significant relationship between a company’s current and past
6,3 capital structure, which can – as the results obtained in this study document – not be
interpreted by a target adjustment behaviour of the sample companies (see Antoniou
et al., 2008, p. 75).

5. Robustness
254 To test the robustness of our results we changed the independent variables used in the
regression model and used the target variables used by Titman and Wessels (1989)
instead[14].The results of those robustness test are reported in Table III.
As can be identified, the results (IAS) of these robustness tests confirm the prior
results that the Indonesian sample companies adjusted their capital structures towards
their target levels relatively faster during the years of the Asian crisis than thereafter,
which is in contrast to the data reported in Table I and the results reported in Figures 1
and 2.
We performed further robustness tests (not reported) in which we used differently
defined capital structure measures, such as a company’s total liabilities to total asset
ratio. As these results are de facto identical with those reported in Tables II and III we
feel confident that our results are not influenced by the definition of the dependent and
independent variables used.
It should also be noted that a similar study can be carried out to investigate the
capital structure adjustment in other countries in the centre of the Asian financial
crisis. However, due to the constraint of data and space, we focus only on Indonesia in
this paper.

6. Summary and conclusions

At the beginning of this study, we raised the question whether capital structure target
adjustment studies mean what they say. To answer this question, this study focused on
a sample of companies that were going through a period of extremely adverse economic
and financial market conditions that would easily allow us identifying whether these
companies adjusted their capital structures towards a certain target or not[15].
Based on the results obtained, we cannot be sure whether commonly used capital
structure tests are really able to identify whether companies adjust their capital
structures towards a certain target or whether economic fluctuations and financial
market changes are behind the identified capital structure changes. As the identification
of the underlying reasons for capital structure changes has important implications for the
validity of the different capital structure theories, especially the trade-off and pecking
order theory, the “horse race” between the last two theories seems still to be open.
Given the problems of existing capital structure target adjustment studies, the
question arises what possible ways forward would be? In our opinion, future tests that
aim to provide some evidence for or against the main capital structure theories – the
trade-off and pecking order theory – have to overcome (at least) the following problems.
First, the problem of simultaneity between a company’s current and target capital
structure ratio, which is commonly ignored in most capital structure target adjustment
studies. Second, the problem that the regression results for the independent variables
included in target adjustment regressions models are not directly comparable with those
of prior (“standard”) capital structure studies. Finally, future capital structure target
 OLS FE FM LSDVC GMM-SYS
1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005

LT-Debt/TA [t-1] 0.59*** 0.65*** 0.02 0.35*** 0.60*** 0.65*** 0.37*** 0.65*** 0.44*** 0.67***
(10.18) (21.72) (0.20) (8.59) (27.55) (15.83) (4.04) (9.64) (3.06) (10.33)
TAN-TW 0.05 0.00 0.11* 20.06 0.05** 0.01 0.19** 0.03 0.11 0.04
(1.38) (0.06) (1.71) (21.17) (3.29) (0.61) (2.08) (0.56) (1.07) (1.33)
SIZE-TW 0.01** 0.02*** 20.04 0.00 0.01 0.02** 20.06 0.05 0.03 0.01
(2.03) (4.56) (21.14) (0.03) (1.30) (2.73) (21.25) (1.24) (1.22) (1.01)
PROFIT-TW 20.14** 20.13*** 0.09 20.45*** 20.11** 2 0.12*** 0.29 20.25* 0.01 2 0.05
(22.15) (23.65) (0.41) (23.58) (23.18) (2 6.40) (0.83) (21.72) (0.08) (2 0.75)
GROWTH-TW 0.24 0.05 20.09 0.20 20.01 2 0.02 20.06 0.19 20.15 0.13
(1.52) (0.39) (20.47) (1.30) (20.04) (2 0.11) (20.18) (1.23) (20.30) (0.85)
CONST 20.06 20.18** 0.61 0.25 0.07 2 0.08 n.a. n.a. 20.38 2 0.15
(20.48) (22.35) (1.40) (0.69) (0.36) (2 0.69) n.a. n.a. (21.13) (2 1.18)
R2 0.44 0.67 0.07 0.47 0.49 0.71 n.a. n.a. n.a. n.a.
F 20.29 69.65 0.83 17.47 0.09 121.27 n.a. n.a. 8.56 119.89
p 0.00 0.00 0.53 0.00 1.00 0.00 n.a. n.a. 0.00 0.00
IAS 2.44 2.85 1.02 1.55 2.51 2.89 1.59 2.88 1.77 3.01
Notes: * denote significant levels at the 10 per cent level; ** denote significant levels at the 5 per cent level; *** denote significant levels at the 1 per cent
level; this table shows the regression results for the capital structure target adjustment model illustrated in Equation (5). OLS ¼ ordinary least square
regressions, FE ¼ fixed effect regressions, FM ¼ Fama-MacBeth regressions, LSDVC ¼ least square dummy variable “corrected” regressions, GMM-
SYS ¼ two-step system GMM regression results. Fama-MacBeth regression results are obtained by using the user-written Stata command “xtfmb” from
Daniel Hoechle. LSDVC results are obtained by using the user-written Stata command “xtlsdvc” from Giovanni S. F. Bruno. The GMM-SYS results are
obtained by using the user-writen Stata command “xtabond2” from David Roodman (2006). The definitions of the independent variables are given in
Section 5. The implied adjustment speed (IAS) in years is calculated by the inverse difference of unity and the LT-Debt/TA[t2 1] estimator. T-statistics are
in parentheses

adjustment – robustness
Capital structure

variable: LT-Debt/TA
tests – Dependent
Regression results target
target

Table III.
255
IJMF adjustment studies have to come up with new ways for the identification and
6,3 measurement of a company’s capital structure target in order to separate a possible
capital structure target adjustment behaviour from capital structure changes that are
caused by changes in economic or financial market conditions.

256 Notes
1. The terms “optimal” and “target” capital structure are often used synonymous in the
literature. Following this convention, the term “target” capital structure is used to describe a
company’s optimal capital structure in the following.
2. An adjustment speed of 30 per cent implies that companies need on average around 3.3 years
(1/0.30) until they reach their desired capital structure target levels.
3. CSit is a company’s current capital structure and CS *it is a company’s target capital structure.
4. DeHaas and Peeters (2006) use a one year lagged target capital structure variable in their
target adjustment model based on the consideration that companies have to know
their capital structure target at the beginning of the year before they can start to adjust their
capital structures towards it. In robustness tests, they show that the use of a company’s
current or its one year lagged capital structure target variable has no significant influence on
the results obtained.
5. The previously mentioned capital structure target adjustment studies include various
variables (Xjit) that they use as a proxy for a company’s optimal or target leverage ratio. No
consensus has, however, been reached on what variables to include in the vector Xjit that is
used to determine a company’s capital structure target.
6. Fama-MacBeth regressions models run t cross sectional regressions and to take the average
of the t regression estimators as an approximation of the “true” regression estimator (Fama
and MacBeth, 1973). The averaging of the regression estimators, assumes that the
t regression estimators are independent of each other. In the presence of unobserved time
invariant effects, this assumption does however not hold resulting in biased regression
outcomes. To overcome this problem, some authors suggest adjusting the Fama-MacBeth
regression estimators and standard errors for the autocorrelation that exists between the
regression estimators. Yet, Petersen (2007) shows that those adjustments do not change the
bias of the Fama-MacBeth regression estimators. The reason for this (remaining) bias is that
the serial correlation that exists between the t regression estimators – and which is used to
correct for the autocorrelation among them – is not the same as the one that causes the bias
in the Fama-MacBeth regression estimators.
7. In a panel data regression model with unobserved effects, OLS regressions are biased, as
both, the dependent and the lagged dependent variable, are a function of the unobserved
effect (see, e.g. Baltagi, 2005). A fixed effect panel data regression model, which eliminates
the unobserved effects, would still be biased, as the dependent and lagged dependent
variable are both correlated with the time-demeaned error terms. Nickel (1981) shows that
fixed effect regression estimators are biased even if the number of cross-sectional units goes
to infinity. If, on the other hand, the number of time-periods increases, the bias of the fixed
effect regression estimator decreases. Monte Carlo simulations of Judson and Owen (1999)
demonstrate however that the bias of the fixed effect regression estimator in lagged
dependent variable regression models remains significant, even if 30 time-periods are
available.
8. For example, the LSDVC regression model assumes that all regression estimators are strictly
exogenous. GMM regression models on the other hand do not allow cross-sectional
correlations of the error terms and might suffer from weak instrument bias (Bun and
Windmeijer, 2007).
 9. As can be identified, the regressions are run for the periods 1997-2000 (crisis period) and the Capital structure
period 2001-2005 (post-crisis period). Four years of data are lost (1995-1996 and 2006-2007)
due to the variable calculation procedure used for the robustness tests (see below). To allow a target
direct comparison of the results reported in Table II and the robustness tests reported in
Table III, we decided to run both regressions for the same periods.
10. The tangibility variable is defined as a company’s net property plant and equipment scaled
by its total assets. A company’s size is proxied by the natural logarithm of its total assets.
The profitability variable is defined as a company’s return on total assets and the growth 257
variable is a company’s market to book ratio.
11. That is because they are the product of the adjustment speed and their own regression
estimator.
12. Not reported significance tests indicate that the adjustment speed measures for the period
after the Asian crisis period are statistically significant different from the adjustment speed
measures during the years of the Asian crisis.
13. According to D’Mello and Farhat (2008) the average respectively moving average capital
structure measures are the best available proxies for a company’s target capital structure
measure.
14. That is, in this robustness test a company’s tangibility (TAN-TW) is calculated by the sum
of a company’s inventory and gross property, plant and equipment scaled by its total assets.
The alternative size (SIZE-TW) figure is calculated as a three-year moving average figure of
a company’s logarithm of total assets. Similarly, a company’s profitability (PROFIT-TW) is
calculated by its three-year moving average operating profit and the alternative growth
measure (GROWTH-TW) is calculated by the quotient of a company’s capital expenditures
scaled by a company’s total assets.
15. As the results of the target adjustment regressions for the sample of Indonesian companies
used in this study are de facto identical to previous capital structure target adjustment
studies, we believe that similar shortcomings of capital structure target adjustment models
can be identified for other samples of companies (e.g. US, European, etc.) and investigation
periods, which future research will have to prove.

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Further reading
Asian Development Bank (1999), Rising to the Challenge in Asia: A Study of Financial Markets:
Volume 6 – Indonesia, Asian Development Bank, Mainla.

Corresponding author
Ludwig Reinhard can be contacted at: lreinhard7@yahoo.com

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