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PeckingOrder

Theory

July 12

2011This Paper examines the pecking order theory and the extent to whichevidence 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.

Evidence fromManufacturing

Firms in

Indonesia

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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 research findings reported in the paper

provide further substantial evidence broadly describing pecking order financing behavior

amongst the manufacturing companies.

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INTRODUCTION.

The article is titled as The Pecking Order Theory: Evidence from Manufacturing Firms in

Indonesia written by Siti Rahmi Utami, Eno L. Inanga from Maastricht School of Management,

The Netherlands. It was published by Independent Business Review, Volume-I, No.2. In July

2008 covering pages 1-24. A fundamental issue in corporate finance understanding how firms

choose their capital structure in the course of their operations.

The optimal capital structure theory evolved through the writings of Franco Modigliani and

Merton Miller (MM, 1958). At first they proposed that, in a world of no income taxes and

transaction costs, a firms capital structure is irrelevant to its value. The proponents of trade off

theory argued that with the introduction of corporation income Taxes and transaction costs (MM,

1963), it was proposed that a firm would use its debt financing judiciously so that its tax saving

would balance its chance of potential bankruptcy. Hence the evolution of the notion of optimal

capital structure where the debt/equity mix would be such that the firms weighted average cost

of capital would be minimized and its value would be maximized.

Myers (1984) and Majluf disagreed with the proposition of trade off theory and propounded the

pecking order theory with the following outline.

Firms prefer internal finance.

They adapt their target dividend payout ratios to their investment opportunities, althoughdividends are sticky and target payout ratios are only gradually adjusted to shifts in the

extent of valuable investment opportunities.

Sticky dividend policies, plus unpredictable fluctuations in profitability and investmentopportunities, mean that internally generated cash-flow may be more or less than

investment outlays. If it is less, the firm first draws down its cash balance or marketable

securities portfolio.

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If external finance is required, firms issue the safest security first. That is, they start withdebt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a

last resort. In this story, there is no well-defined target debt-equity mix, because there are

two kinds of equity, internal and external, one at the top of the pecking order and one at

the bottom. Each firms observed debt ratio reflects its cumulative requirements for

external finance.

In summary, the POT states that businesses adhere to a hierarchy of financing sources and prefer

internal financing when available; and, if external financing is required, debt is preferred over

equity.

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.

THEME OF STUDY

The pecking order theory is from Myers (1984) and Myers and Majluf (1984). Since it is wellknown, we can be brief suppose that there are three sources of funding available to firms:

Retained earnings, debt, and equity. Retained earnings have no adverse selection problem. The

advantage of financing through retained earnings is absence of flotation costs involved in debt or

equity issues. Furthermore retained earnings do not entail external scrutiny by the capital market

or any institutions. Equity is subject to serious adverse selection problems while debt has only a

minor adverse selection problem. From the point of view of an outside investor, equity is strictly

riskier than debt. Both have an adverse selection risk premium, but that premium is large on

equity. Therefore, an outside investor will demand a higher rate of return on equity than on debt.

From the perspective of those inside the firm, retained earnings are a better source of funds than

is debt and debt is a better deal than equity financing. Accordingly, the firm will fund all projects

using retained earnings if possible. If there is an inadequate amount of retained earnings, then

debt financing will be used. Thus, for a firm in normal operations, equity will not be used and the

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financing deficit will match the net debt issues. In reality, company operations and the associated

accounting structures are more complex than the standard pecking order representation. The

researchers of this article examined and analyzed Indonesian firms 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.

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. The sample size comprised of 18 companies for each period of study, and only includes

the manufacturing sector companies. The analysis involved the technique of ordinary least

squares regression. In statistics, regression analysis refers to techniques for modeling and

analyzing several variables, when the focus is on the relationship between a dependent variable

and one or more independent variables. More specifically, regression analysis helps us

understand how the typical value of the dependent variable changes when any one of the

independent variables is varied, while the other independent variables are held fixed. Most

commonly, regression analysis estimates the conditional expectation of the dependent variable

given the independent variables that is, the average value of the dependent variable when the

independent variables are held fixed. 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. The equations are as follows.

Ser Dependent Variables Independent Variables

1 Net debt issue == a + b deficit + u

2 Net equity issue = a + b deficit + u

3 New retained earning = a + b deficit + u

4 Retained earnings = a + b profitability + c growth + d Size

+ e deficit + f tangibility + u

5 Short term liability = a + b profitability + c growth + d Size


6 Long term liability = a + b profitability + c growth + d Size

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7 Total liability = a + b profitability + c growth + d Size


8 Equity = a + b profitability + c growth + d Size


The definitions of the independent variables in relation to pecking order theory are shortly

discussed below:

I. .Deficit: It is the net amount of debt and equity that firm issues in a given year.

II. Growth Opportunities: According to pecking order theory it has been hypothesized thatgrowth is positively related to debt ratios.

III. Profitability: Profitability has a negative relation to debt ratios.

IV. Size: Size has a positive relation with long term debt and negative relation with shortterm debt.

V. Tangibility: Asset tangibility has positive relation with long term debt ratio and negativerelation with short term debt ratio.

Results of regression of equation 1, 2 & 3

Figure 1: Interpretation of the change of new retain earnings, net debt issues and Net

equity issues

In the first step the researchers examined the relation between deficit as independent variable and

retained earnings, net equity issue and net debt issue as dependent variables. The figure above

reports yearly average data on capital structure components from 1995-2005 consists of 4.48%

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new retained earnings, 1.25 % net equity issues and 6.1% net debt issues over the entire period.

Later regression results of deficit on new retained earnings, net debt issues and net equity issues

on capital structure was carried out from equation 1, 2 & 3 and it was concluded that financial

deficit had negative significant effect on retained earnings. This implied that when firms face

high financial deficit they do not use retained earnings as first financing choice of capital

structure.

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. 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.


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. However tangibility had neither positive

nor significant effect on short term liability. Other results suggested that high growth firms were

more likely to use short term liability than low growth firms. The paper also interpreted that high

deficit frms were less likely o use short term liability than low deficit firms.


IN this equation long term liability was regressed. Here the results suggested that financial

deficit and growth had positive and negative effect respectively on long term liability but not

significant. The results also suggested that large firms were more likely to use long term liability

to finance their investments than small firms. On the oher hand tangibility had positive

significant effect to long term liability whereas profitability had negative coeeficient.


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In this case the total liability was regressed. Tangibility as indicated has a positive effect but not

significant. 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. On the other hand larger firms are more likely to use total liability than

small firms.


Equation 8 shows regression of equity. Here growth and tangibility have positive but not

significant effect on equity. 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. Finally, the correlation analysis shows that profitability has a negative

significant relationship with financing deficit. Growth has positive significant relationship with

deficit. It implies that firms in the sample with higher growth also tend to have higher financing

deficit. Growth has negative significant relationship with asset tangibility. It implies that firms in

the sample with growth have lower asset tangibility. Financing deficits has negative significant

relationship with asset tangibility. This implies that firms in the sample with higher financing

deficit have lower asset tangibility.

GENERATION OF THE QUESTIONS

What explains the behavior of Indonesian firms capital structure behavior: the trade offtheory or the pecking order?

Does the agency theory interfere with the trade off theory and the pecking theory in theIndonesian context?

How far is it practicable with firms having higher growth opportunities to follow peckingorder theory?

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What should be the optimal capital structure behavior of a firm having higher financingdeficit?

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. The funding comes from profit, retained earnings,

stock up on (starting from the source of funds with the cheapest cost). 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. Thus when Indonesian firms face high financing

deficits, 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.

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, size and deficit etc. Here the authors used only the results to identify the significance

of relationship with the dependent variables. As we have found from the results that the

relationships did not support the pecking order theory the authors could have recommended

Whether any other ways or procedures could have been undertaken by the firms to support the

pecking order theory.

CONCLUSION

Financial deficit has a positive significant influence on net equity and net debt issues. 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. Meanwhile, when the firms face low financing deficit, they tend to use more

retained earnings in their capital structure to finance investments. This finding also does not

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support the proposition of the pecking order theory that retained earnings are the first preferred

funding source and equity as last resort. The Indonesian market had been defined as emerging

market that potentially grants a good investment to its investor. This study provided a brief

guideline and reference for investor, lender, share holder and debt holder for better

understanding of Indonesian market. 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.

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,

other than manufacturing. This could be especially important for less capital intensive industries

with more modest financing requirements than manufacturing.

REFERENCES

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Capital Structure; A Critical Comment. Journal of Financial Economics 58, 417-425.

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Analysis. CERGUs Project reports, 4 (1), 1-32

Fama, E., French, K., 2002. Testing Trade Off and Pecking Order Predictions about Dividends

and Debt. The Review of Financial Studies 15, 1-33

Francisco sogorb-mira y jos lpez-gracia.Pecking order versus trade-off:

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