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Evidence from Manufacturing Firms in Indonesia
This Paper examines the pecking order theory and the extent to which evidence from manufacturing firms in Indonesia support it. Based on this, the paper goes on to analysis the determinants of the capital structure of in the sector of the Indonesian company.
The research findings reported in the paper provide further substantial evidence broadly describing pecking order financing behavior amongst the manufacturing companies.Executive Summary A fundamental issue in corporate financing is to understand how firms choose their capital structure in the course of their operations. . The principal objective in this paper is to ascertain the extent to which Myers¶ (1984) Pecking Order Theory (POT) of business financing appears to explain financial structure amongst a panel of 18 manufacturing companies taken from the Indonesian Stock exchanges main board companies.
The proponents of trade off theory argued that with the introduction of corporation income Taxes and transaction costs (MM. a firm¶s capital structure is irrelevant to its value. 1963).´ Volume-I. . the firm first draws down its cash balance or marketable securities portfolio. 1958).INTRODUCTION. It was published by ³Independent Business Review. The optimal capital structure theory evolved through the writings of Franco Modigliani and Merton Miller (MM. They adapt their target dividend payout ratios to their investment opportunities. it was proposed that a firm would use its debt financing judiciously so that its tax saving would balance its chance of potential bankruptcy. in a world of no income taxes and transaction costs. mean that internally generated cash-flow may be more or less than investment outlays. If it is less. Firms prefer internal finance. The Netherlands. The article is titled as ³The Pecking Order Theory: Evidence from Manufacturing Firms in Indonesia´ written by Siti Rahmi Utami. In July 2008 covering pages 1-24. At first they proposed that. No. Inanga from Maastricht School of Management. plus unpredictable fluctuations in profitability and investment opportunities. Eno L. Myers (1984) and Majluf disagreed with the proposition of trade off theory and propounded the pecking order theory with the following outline. A fundamental issue in corporate finance understanding how firms choose their capital structure in the course of their operations. Hence the evolution of the notion of optimal capital structure where the debt/equity mix would be such that the firm¶s weighted average cost of capital would be minimized and its value would be maximized. Sticky dividend policies.2. although dividends are sticky and target payout ratios are only gradually adjusted to shifts in the extent of valuable investment opportunities.
the POT states that businesses adhere to a hierarchy of financing sources and prefer internal financing when available. because there are two kinds of equity. equity is strictly riskier than debt. Retained earnings have no adverse selection problem. internal and external. Accordingly. THEME OF STUDY The pecking order theory is from Myers (1984) and Myers and Majluf (1984). for a firm in normal operations. equity will not be used and the . That is. then perhaps equity as a last resort.If external finance is required. If there is an inadequate amount of retained earnings. Since it is well known. debt. In summary. The advantage of financing through retained earnings is absence of flotation costs involved in debt or equity issues. Thus. if external financing is required. an outside investor will demand a higher rate of return on equity than on debt. Furthermore retained earnings do not entail external scrutiny by the capital market or any institutions. From the point of view of an outside investor. From the perspective of those inside the firm. the firm will fund all projects using retained earnings if possible. Therefore. but that premium is large on equity. there is no well-defined target debt-equity mix. firms issue the safest security first. and. one at the top of the pecking order and one at the bottom. debt is preferred over equity. Each firm¶s observed debt ratio reflects its cumulative requirements for external finance. then debt financing will be used. retained earnings are a better source of funds than is debt and debt is a better deal than equity financing. we can be brief suppose that there are three sources of funding available to firms: Retained earnings. then possibly hybrid securities such as convertible bonds. they start with debt. In this story. Both have an adverse selection risk premium. MAIN ISSUE The main issue of this paper is to examine the extent to which evidence from manufacturing firms in Indonesia supports the pecking order theory and on the basis of findings to analyze the determinants o capital structure in Indonesian firms in manufacturing sector. Equity is subject to serious adverse selection problems while debt has only a minor adverse selection problem. and equity.
The equations are as follows. the average value of the dependent variable when the independent variables are held fixed. when the focus is on the relationship between a dependent variable and one or more independent variables. company operations and the associated accounting structures are more complex than the standard pecking order representation. Ser 1 2 3 4 Dependent Variables Net debt issue == Net equity issue = New retained earning = Retained earnings = Independent Variables a + b deficit + u a + b deficit + u a + b deficit + u a + b profitability + c growth + d Size + e deficit + f tangibility + u 5 Short term liability = a + b profitability + c growth + d Size + e deficit + f tangibility + u 6 Long term liability = a + b profitability + c growth + d Size . In statistics. The sample size comprised of 18 companies for each period of study. The researchers of this article examined and analyzed Indonesian firm¶s financial characteristics in real practical scenario the extent to which the Pecking Order Theory of capital structure was applied over the 1994 to 2005 period. In reality. ANALYSIS AND INTERPRETATION The Authors of this article collected data of companies from Indonesian stock Exchange Main board companies and macro economics data from Indonesian Statistical Centre from 199 to 2005.financing deficit will match the net debt issues. regression analysis estimates the conditional expectation of the dependent variable given the independent variables ² that is. regression analysis helps us understand how the typical value of the dependent variable changes when any one of the independent variables is varied. Most commonly. while the other independent variables are held fixed. The analysis involved the technique of ordinary least squares regression. and only includes the manufacturing sector companies. More specifically. In this research 8 equations have been formulated for the purpose of examining the casual relationships between each independent variable and one or more independent variables. regression analysis refers to techniques for modeling and analyzing several variables.
Profitability: Profitability has a negative relation to debt ratios. Results of regression of equation 1. IV. Tangibility: Asset tangibility has positive relation with long term debt ratio and negative relation with short term debt ratio. net equity issue and net debt issue as dependent variables.48% . V. Size: Size has a positive relation with long term debt and negative relation with short term debt. 2 & 3 Figure 1: Interpretation of the change of new retain earnings. .+ e deficit + f tangibility + u 7 Total liability = a + b profitability + c growth + d Size + e deficit + f tangibility + u 8 Equity = a + b profitability + c growth + d Size + e deficit + f tangibility + u The definitions of the independent variables in relation to pecking order theory are shortly discussed below: I. II. The figure above reports yearly average data on capital structure components from 1995-2005 consists of 4. net debt issues and Net equity issues In the first step the researchers examined the relation between deficit as independent variable and retained earnings.Deficit: It is the net amount of debt and equity that firm issues in a given year. Growth Opportunities: According to pecking order theory it has been hypothesized that growth is positively related to debt ratios. III.
On the other hand firms with high profitability and with high tangible assets were more likely to use internal financing sources for their investments than those of low profitability and low asset tangibility. Results of Regression of equation 5 The next regression was short term liability where it was seen that profitability and size had positive but no significant effects on short term liability.25 % net equity issues and 6.1% net debt issues over the entire period. Results of Regression of equation 4 In equation 4 the paper regressed retain earning where it was found that growth and financing deficit had negative effects while size had positive effect on retain earnings but none of them significant. This implied that when firms face high financial deficit they do not use retained earnings as first financing choice of capital structure. net debt issues and net equity issues on capital structure was carried out from equation 1. Results of Regression of equation 6 IN this equation long term liability was regressed. However tangibility had neither positive nor significant effect on short term liability. Later regression results of deficit on new retained earnings. Here the results suggested that financial deficit and growth had positive and negative effect respectively on long term liability but not significant. On the oher hand tangibility had positive significant effect to long term liability whereas profitability had negative coeeficient. Results of Regression of equation 7 . 2 & 3 and it was concluded that financial deficit had negative significant effect on retained earnings.new retained earnings. The results also suggested that large firms were more likely to use long term liability to finance their investments than small firms. The paper also interpreted that high deficit frms were less likely o use short term liability than low deficit firms. Other results suggested that high growth firms were more likely to use short term liability than low growth firms. 1.
On the other hand high profitable firms are also more likely to use equity than those with low profitability whereas firms with larger size are more likely to use less equity than small firms.In this case the total liability was regressed. This implies that firms in the sample with higher financing deficit have lower asset tangibility. On the other hand larger firms are more likely to use total liability than small firms. Finally. Financing deficits has negative significant relationship with asset tangibility. The results on profitability and financing deficit suggested that firms with high profitability or high financing deficit are less likely total liability than low profitable and low deficit firms respectively. the correlation analysis shows that profitability has a negative significant relationship with financing deficit. Results of Regression of equation 8 Equation 8 shows regression of equity. Growth has negative significant relationship with asset tangibility. GENERATION OF THE QUESTIONS What explains the behavior of Indonesian firm¶s capital structure behavior: the trade off theory or the pecking order? Does the agency theory interfere with the trade off theory and the pecking theory in the Indonesian context? How far is it practicable with firms having higher growth opportunities to follow pecking order theory? . It implies that firms in the sample with growth have lower asset tangibility. Tangibility as indicated has a positive effect but not significant. Here growth and tangibility have positive but not significant effect on equity. It implies that firms in the sample with higher growth also tend to have higher financing deficit. Growth has positive significant relationship with deficit.
size and deficit etc. stock up on (starting from the source of funds with the cheapest cost). This finding also does not . The funding comes from profit. Meanwhile. POLICY PRESCRIPTIONS The researchers in the paper used regression technique to examine the relationships between each independent variable and one or more independent variables such as growth profit tangibility. What should be the optimal capital structure behavior of a firm having higher financing deficit? Does the trade off theory coexist in parallel with pecking order theory? What does pecking order theory recommends in the event of bankruptcy? How does leverage theory co relates with pecking order theory? SUMMARY The Pecking Order Theory states that firms will prefer internal financing to external financing when fund are needed for new investment. Here the authors used only the results to identify the significance of relationship with the dependent variables. they do not use retained earnings as their first source of investment financing in their capital structure contrary to the proposition of pecking order theory. when the firms face low financing deficit. CONCLUSION Financial deficit has a positive significant influence on net equity and net debt issues. retained earnings. they tend to use more retained earnings in their capital structure to finance investments. As we have found from the results that the relationships did not support the pecking order theory the authors could have recommended µWhether any other ways or procedures could have been undertaken by the firms¶ to support the pecking order theory. But the study reported in this paper has found that financial deficit has significant negative effect on retained earnings of firms in the manufacturing sector of Indonesia. This finding indicates that when Indonesian manufacturing firms face high financing deficits they tend to use more net equity and net debt in their capital structure to finance long term investments. Thus when Indonesian firms face high financing deficits.
2002. lender. REFERENCES P Murray Z. A. CERGU¶s Project reports.Capital Structure: theories and Empirical results ± A Panal Data Analysis. Chirinko.. DIRECTIONS FOR FUTURE RESEARCH There is a clear need to ascertain the extent to which the Pecking order Theory of business financing appears to explain financial structure amongst SMEs in industries and other sectors. The Review of Financial Studies 15. share holder and debt holder for better understanding of Indonesian market. Journal of Financial Economics 58. Journal of Financial Economics 00 (2002) 000-000. Testing Trade Off and Pecking Order Predictions about Dividends and Debt . K. 4 (1).. Chen. French. E. 1-32 Fama. Singha.. This could be especially important for less capital intensive industries with more modest financing requirements than manufacturing. & hammes. R. 2000. The Indonesian market had been defined as emerging market that potentially grants a good investment to its investor.support the proposition of the pecking order theory that retained earnings are the first preferred funding source and equity as last resort. other than manufacturing. Testing Static Trade Off Against Pecking Order Models of Capital Structure. The overall conclusion of the study based on the finding of this article is that the financing behavior of firms listed in the manufacturing sector of the Indonesia Stock Exchange does not support the propositions of the pecking order theory. This study provided a brief guideline and reference for investor. 1-33 Francisco sogorb-mira y josé lópez-gracia. K (2003). Frank &Vidhan K. Website. Y. 417-425. A Critical Comment. .. Goyal. Testing the pecking order theory of capital structure. Pecking order versus trade-off: An empirical approach to the small and Medium enterprise capital structure.
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