Institutional Ownership, Profitability, Tangibility, and Liquidity on

Firms’ Capital Structure

Beny and Erika

Trisakti School of Management, Kyai Tapa No. 20, 11440, Jakarta, Indonesia

Keywords: Capital Structure, Institutional Ownership, Profitability, Tangibility, and Liquidity.

Abstract: The purpose of this research is to identify the influence of institutional ownership, profitability, tangibility,

and liquidity on capital structure. The sample in this research is sub-sector automotive and component

companies which are listed in Indonesian Stock Exchange between the years of 2013-2017. This research

uses purposive sampling method and multiple regression to see the contribution of each variable in

influencing capital structure. The results showed that institutional ownership, profitability, tangibility have

no influence toward capital structure whereas liquidity does have an influence toward capital structure.

1 INTRODUCTION

Every company that wants to start its business

activities requires capital in its own business. Capital

is one of the important things when starting a

business. Therefore, the company must be able to

determine how much capital is needed to finance its

business activities.

Capital needed by the company can be obtained

from various sources and with different types. The

capital can be obtained from debt and equity. In this

case, the company has its own goal of increasing the

value of the company through increasing the welfare

of the owner or shareholders. Financial management

aims to maximize the welfare of the owners

(shareholders) through decisions or investment

policies, funding, and dividends that are reflected in

the stock price in the capital market. In its efforts to

manage and run the company, managers need to

fund its business expansion activities. One

alternative for the company to meet the fund is by

issuing debt.

Debt policy is part of consideration in the capital

structure. Capital structure is a financing consisting

of long-term debt, preferred stock, and shareholder

capital. After knowing the impact of differences in

interests between shareholders and management in

determining capital policy, the company is expected

to be able to balance capital structure optimally

including debt policy which is also a consideration

in the capital structure in order to minimize capital

costs and avoid conflicts between shareholders and

management.

Modigliani and Miller (1958 and 1963) in Lim

(2012) showed that, in theory, without taxes and

information asymmetries, capital structure has no

impact on firm value. The Modigliani-Miller

Theorem proposed that, under perfect market

conditions, a firm’s financial decisions do not

matter. Modigliani and Miller (1958) established the

modern theory of capital structure where it stated

that a firm’s debt-equity ratio does not affect its

market value. How a firm choose to finance its

investment is irrelevant. Modigliani and Miller's

theories in 1963 assumed the existence of a tax on

corporate income. With this tax, MM concludes that

the use of debt will increase the value of the firm

because the debt interest cost is the tax deductible

expense (Sjahrial, 2010: 193).

The problem in this study is whether institutional

ownership, profitability, tangibility, and liquidity

affect the firms’ capital structure. This study

examines the effects of factors with proven

influences on capital structure in literature, along

with industry effect and ownership effect.

2 LITERATURE REVIEW

The Agency cost theory (Jensen and Meckling,

1976; Jensen, 1986) in Chen, et al., (2014) claims

that the optimal utilization of debt could increase the

value of shareholders but overwhelming debt

financing may cause damage. Firms incur agency

cost to ensure agents (managers) act in the best

Beny, . and Erika, .

Institutional Ownership, Proﬁtability, Tangibility, and Liquidity on Firms’ Capital Structure.

DOI: 10.5220/0008491502570262

In Proceedings of the 7th International Conference on Entrepreneurship and Business Management (ICEBM Untar 2018), pages 257-262

ISBN: 978-989-758-363-6

257

interests of principals (shareholders). When there is

a separation between ownership and management,

the conflict of goals between managers and owners

and between different stakeholders emerges. For

instance, equity holders with residual claims and

limited liability concern more about profit from

venture investment, while the debt-holders concern

more the security of their claims. Morellec et al.

(2012) in Chen et al., (2014) examine the conflicts

between shareholders and agents in capital structure

decisions and confirm the conflicts in choosing an

optional capital structure and how governance

mechanism mitigating the issue.

The pecking order theory (Myers and Majluf,

1984) in Chen et al., (2014) proposes that firms

usually prefer internal finance to external finance

and prefer debt to equity when internal finance is

insufficient. This is to avoid adverse effect of

asymmetric information that investors tend to

believe that firms issue equity when stock prices are

overpriced and therefore stock price would fall after

stock issue is announced. This debt policy is also

related to the pecking order theory which states that

if a company requires funds, the main priority is to

use internal fund which is called retained earnings,

because of asymmetric information, external funding

is less desirable. If external funding is needed, the

priority is debt, then the converted equity, and then

the issuance of new shares. This theory occurs when

asymmetric information indicates that managers

know more about the prospects, risks, and values of

the company than outside investors.

The trade-off theory argues that a firm is faced

with increased financial risk when obtaining tax

saving from debt financing (Kraus and Litzenberger,

1973) in Chen et al., (2013) and the optimal capital

structure can be achieved when the marginal present

value of the tax shield is equal to the marginal

present value of the costs of financial distress arising

from additional debt (Warner, 1977) in Chen et al.,

(2013). In actual conditions, there are things that

make the company unable to maximize the debt as

much. This is because the higher the debt the greater

the interest to be paid. The company will owe up to

certain debt levels, where the tax savings from

additional debt equals the cost of financial

difficulties. The cost of financial difficulties is the

cost of bankruptcy or reorganization, and the

increased agency costs resulting from the decline of

a company's credibility. According to Megginson

(1997, 322), there are several factors included in the

trade-off theory in determining optimal capital

structure such as: taxes, agency costs, asset

characteristics, ownership structure, and costs of

financial difficulties. However, this still maintains

the assumption of market efficiency and asymmetric

information as consideration and benefits of using

debt. Achievement of optimal debt level is reached

when the tax savings reached the maximum amount

of the cost of financial distress. Financial distress is

a condition in which a company experiences

financial difficulties and is threatened with

bankruptcy. If the company goes bankrupt, then

bankruptcy costs will arise which are caused by

compulsion to sell assets below market prices,

company liquidation costs, and so on (Sjahrial,

2010, 202).

2.1 Institutional Ownership and

Capital Structure

According to the agency theory, Jensen and

Meckling (1976) described that total agency costs

could be minimized by the optimal structure of

leverage and ownership, but no clear predication is

concerned with the relationship related to debt level

(Huang and Song, 2006) in Lim (2012). Agency

theory suggests that ownership structure is

correlated with financing decision due to conflicts of

interests between different stakeholders (Chen,

2013). Furthermore, Myers and Majluf (1984) in

Sias (2004) stated that if institutional information –

gathering and trading produces information, the

adverse selection costs of equity may decline, thus

leading firms to tilt toward a higher percentage of

equity financing in their capital structures, and

institutional holding and debt would be substitutes.

According do Douma, George, and Kabir (2003) in

Pirzada et al. (2015), the firms with higher level of

debt, cost of capital would be higher. In such

scenario, a firm will have to perform better than it

would have been otherwise. McConnell and Servaes

(1995) in Pirzada et al., (2015) argued that firm

value and capital structure could be closely

correlated. On the one hand, high leverage may

reduce the agency cost of outside equity, and

increase firm value by encouraging managers to act

more in the interest of shareholders. More efficient

firms may also choose higher equity capital ratios,

all else equal, to protect the rents or franchise value

associated with high efficiency from the possibility

of liquidation. If leverage is relatively high, further

increases may generate significant costs including

bankruptcy cost and may thus lower firm value.

H1: Institutional ownership has a significant effect

on capital structure.

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2.2 Profitability and Capital Structure

Profitability measures the effectiveness of the

business in generating profits. According to the

capital structure theory, Myers and Majluf (1984) in

Lim (2012) demonstrated that firms have a pecking

order in funding their activities and they preferred

internal finance to external finance. This theory

predicts that the relationship between profitability

and capital structure is negative. Generally, firms

with higher profitability tend to create more capital

flow to enterprises and then the sufficient retained

earnings internally generated could be utilized as

internal finance. However, the signalling theory

predicts a different opinion that profitability and

financial leverage is positively correlated. Higher

leverage indicates the good performance of business,

thus managers and investors are more confident

about future operation. Jensen (1986) in Lim (2012)

pointed out that the relationship is likely to be

positive, while Titman and Wessles (1988) in Lim

(2012) predicted that larger firms may tend to have a

higher debt capacity. Modigliani and Miller (1963)

in Vo (2017) state that a company may opt for debt

in order to take advantage of tax shields. Moreover,

(Friend and Lang, 1988; Harris and Raviv, 1991:

Rajan and Zingales, 1995; Booth et al., 2001: Sbeti

and Moosa, 2012) in Vo (2017) stated that the

relationship between the capital structure and

profitability is both theoretically and empirically

controversial. In the trade - off theory, more

profitable firms should have higher leverage because

they have more income to shield from taxes

(Acaravci, 2015), but in the pecking – order theory,

firms prefer internal financing to external. So more

profitable firms have a lower need for external

financing and therefore should have lower leverage

(Bauer, 2004) in Acaravci (2015). Under the agency

cost theory, Williamson (1988) in Chen (2013)

argued that debt can be seen as a disciplining device

for managers to ensure they maximize profit for

shareholders rather than go on an excessive pursuit

of firm growth. La Rocca et al. (2009) in Vo (2017)

argue that more profitable firms are more likely to

borrow more in order to benefit from the tax shield.

H2: Profitability has a significant effect on capital

structure.

2.3 Tangibility and Capital Structure

Most of the empirical researches confirm that the

tangibility of assets affect the firms’ capital

structure. Based on the agency cost theory created

by Jensen and Meckling (1976) in Lim (2012) there

is a positive relationship between the fraction of

tangible assets and capital structure. An enterprise

with a high proportion of fixed assets is expected to

be associated with high ability to repay their

liabilities, thus more opportunities to raise that

financing. Both the agency theory and trade – off

theory suggest that tangible assets are important and

positively determine capital structure. On the one

hand, because tangible assets can be used as

collateral, a high fraction of tangible assets allows

the firm to obtain external finance easily resulting in

a high leverage (Titman and Wessels, 1988: Sbeti

and Moosa, 2012) in Vo (2017). Moreover, the

tangibility of the firm’s assets is closely associated

with agency cost of debt and the cost of financial

funds (Myers, 1977; Booth et al., 2001) in Vo

(2017). Jensen and Meckling (1976) in Vo (2017)

affirm that if firms do not have collaterals for their

debt, moral hazard and hence agency costs of debt

increase. Tangible assets are more valuable on the

market than intangible assets in the case of

bankruptcy, and so bondholders will demand lower

risk premiums. Tangible assets can also mitigate

concerns over insider resource expropriation.

Moreover, the use of collateral plays a more

important role in countries where creditor protection

is relatively weak, and it is commonly accepted that

emerging countries are in this weak creditor

protection group (La Porta et al., 1998) in Vo

(2017). Myers (1984) stated that firms holding

tangible assets – in – place of having active second –

hand markets will borrow less than firms holding

specialized, intangible assets or valuable growth

opportunities.

H3: Tangibility has a significant effect on capital

structure.

2.4 Liquidity and Capital Structure

Liquidity ratios may have a mixed impact on the

capital structure decision. On the one hand, a

negative relation between capital structure and

liquidity is expected because if firms are having

more debt, they would have the associated higher

liabilities and lower remaining current assets

(Ozkan, 2001) in Vo (2017). Moreover, the agency

theory suggests that when the agency costs of

liquidity are high, outside creditors tend to reduce

the debt financing limit available to firms (Myers

and Rajan, 1998) in Vo (2017). If firms follow the

financing hierarchy of the pecking order theory for

their capital structure decision, it results in a

negative link between liquidity and financial

leverage (Sbeti and Moosa, 2012) in Vo (2017).

Institutional Ownership, Proﬁtability, Tangibility, and Liquidity on Firms’ Capital Structure

259

Liquidity has a significants effect on leverage but

the former can have a positive or negative effect on

the capital structure decision; thus, the net effect is

unknown (Mouamer, 2011) in Ghasemi and Razak

(2016). Moreover, liquidity has a significant effect

on conservative debt policy when the company has

ample liquid assets; hence, conservative policies are

necessary to ignore potential risks. Overall, there is

no universal theory for choosing between debt and

equity. In other words, there are some helpful

conditional theories (Akinlo, 2011) in Ghasemi and

Razak (2016). Submitter and Anderson (2002) in

Ghasemi and Razak (2016) also demonstrated the

positive relationship between liquid assets and long

– term debt characteristics of capital structure with

holding liquid asset as a precautionary solution.

They also showed a negative relation between liquid

assets and short – term borrowings of the firm,

assuming the substitute financing role for them in

situation of lack of cash. Anderson and Carverhill

(2007) in Ghasemi and Razak (2016) find that

higher levels of long – term debt will result in more

reduction in the optimal use of short – term debt and

higher levels of liquid asset holding. Sarlija and

Harc (2012) in Ghasemi and Razak (2016) also find

that there were statistically significant correlations

between leverage ratios and liquidity ratios.

Moreover, there were statistically significant

correlations between the structure of current assets

and leverage ratios.

H4: Liquidity has a significant effect on capital

structure

3 METHODS

The population of this research is sub-sector

automotive and component companies that have

been listed in Indonesia Stock Exchange from 2013

until 2017. This research uses purposive sampling to

determine its samples. This research uses 11

companies and 55 data for sample. It is analysed by

using multiple regression analysis. This table below

shows the list of the company selected:

Table 1: Research Samples.

No Ticker Company

1 ASII Astra Internasional

2 AUTO Astra Otoparts

3 GJTL Gajah Tunggal

4 GDYR Goodyear Indonesia

5 BRAM Indo Kordsa

6 IMAS Indomobil Sukses International

No Ticker Company

7 INDS Indospring

8 LPIN Multi Prima Sejahtera

9 MASA Multistrada Arah Sarana

10 NIPS Nipress

11 PRAS Prima Alloy Steel Universal

The dependent variable in this study is capital

structure, which is how the company funds its

operating activities using debt. This dependent

variable is measured using a ratio scale. This method

of measurement refers to the research conducted by

Acaravci (2015) by dividing total debt to total

equity. The equation for base model may follows as:

Debt equity ratio = α + β1institutional ownership +

β2profitability + β3tangibility +

β4liquidity + ε

Institutional ownership (INST) is used to see

whether there are shares owned by institutions

during this research period. This variable

measurement is measured by the proportion of

shares held by institutions in the form of percentages

(%). This method of measurement refers to research

conducted by Chen, et al., (2014).

Profitability (PROF) is the company's ability to

generate profits in the future. This variable is

measured using a ratio scale. Profitability is

formulated by dividing the operating income with

total asset (Rajan and Zingales, 1995) in Vo (2017).

The ratio fixed assets over total assets will be the

indicator of tangibility (TANG) in this paper. The

measurement is the same as Rajan and Zingales

(1995) in Lim (2012).

In this study, liquidity (LIQ) is calculated as the

ratio of current assets to current liabilities at year

end (Vo, 2017).

4 RESULTS

This table below is the sample’s descriptive

statistics.

Table 2: Descriptive Statistics.

der inst prof tang liq

N Valid 55 55 55 55 55

Mean 1.243 0.6376 0.2034 0.5676 1.5816

Std.

Deviation

1.236 0.2023 2.2136 0.0971 0.9360

Minimum 0.13 0.259 -10.91 0.3215 0.5228

Maximum 8.26 0.9417 7.84 0.7511 5.1662

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The result of the statistical test can be seen in

hypothesis result shown in table 3 below:

Table 3: Hypothesis Result.

Model B t Sig.

(Constant) 3.269 2.754 0.008

INST -0.238 -0.300 0.765

PROF -0.112 -1.553 0.127

TANG -1.740 -1.054 0.297

LIQ -0.546 -3.199 0.002

Adjusted R-Square 0.137

F-Statistic 3.139

(

0.022

)

Table 3 shows that institutional ownership has no

effect on capital structure. This results is not

consistent with Chen, et al. (2014) and Lim (2012).

More or less, the institutional ownership has no

effect on firms’ capital structure. Profitability has no

effect on capital structure. Most of the companies

are big companies, so the finance of their operation

are not based on the capital structure. This result is

not consistent with Chen, et al. (2014) and Lim

(2013). Tangibility has no effect on capital structure.

The firms’ capital structure do not depend on the

size of assets because the assets itself can generate

profit to the company. This result is not consistent

with Chen, et al. (2014) and Lim (2013). Liquidity

has a negative effect (-0.546) on capital structure.

This result is consistent with Vo (2017). It means

that company with higher liquidity tend to borrow

less debt in the automotive and component

companies, because the companies still have enough

cash to cover their short-term obligation. On the

other hand, the firms’ working capital turnover is in

a good condition. This result is also consistent with

the value 0.137 of adjusted R-Square which means

the capital structure can be explained by the

independent variable (13.7%) and the remaining

86,3% is explained by other factors not included in

the model.

5 CONCLUSIONS

The result of this research shows that institutional

ownership, profitability, and tangibility have no

effect on firms’ capital structure. On the other hand,

liquidity has a significant effect on firms’ capital

structure. Generally, in the models, firm specific

variables have significant influences on firms’

capital structure. From the hypothesis result in Table

2, we do not find evidence that institutional

ownership and tangibility have a significantly effect

on capital structure as described by Jensen and

Meckling (1976) in agency cost theory, nor the

damage from overwhelming of debt financing. In

fact, Indonesia is in the first place of automotive

exporting country in ASEAN from 2013 until 2017.

This is also the reason for companies for using their

profitability without depending on debt. Finally, we

found that the effect of liquidity on firm’s capital

structure is explained through increased liquidity

that reduces firm’s debt.

6 SUGGESTION AND

LIMITATION

This research has some limitations which are: using

only the five years period of 2013-2017, consisting

only of automotive and component companies listed

in IDX, and using only four independent variables.

We do suggest to add an additional period of the

research, using more samples not only in Indonesia

but also in ASEAN countries, and further research

may add other variables such as free cash flow,

growth opportunities, and dividend payout ratio to

see more briefly what factors can affect the firms’

capital structure, so the companies can consider

some factors to focus on regarding the firms’

financing.

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