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A note on capital structure target adjustment Indonesian evidence

Ludwig Reinhard
University of South Austrailia and Roedl & Partner-Worldwide Dynamics, Rhineland-Palatinate, Germany

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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 specic dataset by using different regression techniques (ordinary least square, xed 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 nancing (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 model and technique used, those studies typically nd that companies adjust their capital structures with a speed of around 10-30 per cent per year towards their capital
The authors are grateful to an anonymous referee for some useful suggestions.

International Journal of Managerial Finance Vol. 6 No. 3, 2010 pp. 245-259 q Emerald Group Publishing Limited 1743-9132 DOI 10.1108/17439131011056242

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structure targets[2]. Recently, DMello and Farhat (2008) carried target adjustment studies to the extremes by claiming that a companys moving average debt ratio would be the best available proxy for a companys optimal capital structure. Encouraged by the study of DMello 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) 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 nds 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 identied 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 identied 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 briey 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 nancing decisions of companies in the USA and Europe nd empirical evidence for the notion that companies have capital structure targets that inuence their nancing 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 rst and often cited study in this context is from Fama and French (2002), which analyses the nancing decisions of US companies over the years from 1965-1999 and nds 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 nd that companies adjust their capital structures rather quickly towards their 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 nancing decisions of companies from the USA, UK, Germany, France and Japan over the years from 1987 to 2000 nd also some support for the consideration 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 nancing decisions of companies in the US use almost identical datasets. Given these conicting 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 nancing 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 nancial sources, provides some information about important external nancial sources available in Indonesia in general. The lower part, denominated as internal nancial 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 identied from the upper part of Table I (external nancial 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 identied 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 nancial data from the nancial statements of the sample companies. As can be identied, 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

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Year External nancial sources Number of IPOs Volume IPOs Bank and nance Others Number of right issues Volume of right issues Bank and nance Others Number of public debt issues Volume of public debt issues Bank and nance Others Working capital loans Investment loans

1995 17 5,682 16 5,666 10 3,182 380 2,802 4 2,185 370 1,815 175,337 59,274

1996 19 2,662 977 1,686 19 1,1924 3,289 8,636 5 2,841 91 2,750 222,478 70,443

1997 34 3,951 652 3,299 20 15,887 3,188 12,699 15 7,205 1,800 5,405 240,758 100,735

1998 3 68 0 68 10 5,068 2,561 2,506 0 150 0 150 314,208 141,464

1999 12 805 173 632 14 130,682 127,787 2,895 6 4,284 1,050 3,234 143,356 57,691 5,145 67,947 4,830 189,709 452,257 188,413 25,349 149,196 1,071,198 957,244 1,106,816 1,817,466 2,966,856

2000 25 1,772 n.a. n.a. 10 17,548 n.a. n.a. 15 5,613 518 5,095 163,630 65,276 25,146 131,907 6,272 712 567,970 270,871 67,635 172,065 1,205,644 1,450,950 1,326,415 2,412,558 3,790,929

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Internal nancial sources Sale of common and preferred stock 46,876 22,349 71,324 13,773 LT-debt issuance 132,767 148,750 302,173 155,699 Disposal of xed assets 5,057 9,448 11,645 31,666 Net income 76,929 85,620 25,687 46,162 Total sources of funds 319,685 352,308 603,149 495,406 LT-debt retirement 40,561 69,136 114,755 117,660 Dividend payments 20,415 22,251 30,086 17,179 Interest payments 45,236 58,553 117,457 147,270 Current assets 538,828 548,330 884,921 849,064 Current liabilities 321,145 348,925 748,258 824,165 Total common equity 537,276 596,421 683,551 972,881 Total liabilities 704,498 797,815 1,635,180 1,681,970 Total assets 1,279,732 1,434,854 2,364,643 2,675,875

Table I. Target adjustment indicators

Notes: This table shows selected external and internal nancial indicators of the Indonesian economy in general (external nancial sources) and of the sample companies analysed (internal nancial sources). All volume data in the upper external nancial sources part are in billion IDR while all data in the lower internal nancial sources part are in million IDR. The volume gures in the upper external nancial sources part are reported in total, for bank and nance companies and other companies to show possible effects resulting from external market changes on corporate nancing decisions 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 nancial 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 companies have not deliberately adjusted their capital structures towards their target levels over the years of the Asian crisis are the increase in the disposal of xed 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 3.1 Data Initially all listed companies in Indonesia over the years from 1995 to 2007 were selected. Thereafter, all nancial (SIC codes 6000-6999) and utility companies (SIC codes 4900-4999) were excluded as their nancing decisions might be inuenced by minimum capital requirement regulations or explicit or implicit government guarantees. To avoid that outliers inuence 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 inuenced by the Asian crisis. By doing so, we were able to obtain a panel consisting of 749 rm-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]. CSit 2 CSit21 b0 b1*CS 2 CSit21 1it :
*

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The capital structure target adjustment model illustrated in equation (1) is identical to the one commonly used in the literature (see, e.g. DMello and Farhat, 2008) and states that changes in a companys capital structure (CSit CSit2 1) are caused by a * companys desire to adjust its capital structure towards its target level (CSit). A rst problem, which can be identied from equation (1) is the simultaneity between a companys 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 justiable, as DeHaas and Peeters (2006) demonstrate[4]. The target adjustment model in equation (1) can be rearranged as follows: CSit b0 b1*CS 2 b1*CSit21 CSit21 1it which can be further simplied to: * CSit b0 b1*CS 1 2 b1 * CSit21 1it : 3
*

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A problem with the regression model illustrated in equation (3) is that it cannot be * directly estimated, as a companys target leverage ratio (CSit) is not directly observable. To overcome this problem, it is usually assumed that a companys target capital structure ratio is itself a function of other variables (Xjit)[5] that have been found to inuence a companys capital structure decisions, i.e.: CS
*

250

k X j1

aj*Xjit

By inserting equation (4) into equation (3), the following testable model results:
k X CSit b0 1 2 b1 * CSit21 b1* aj*Xjit 1it j1

The main interest in this target adjustment model is the regression estimator (1 2 b1), which is assumed to provide an indication about a companys 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 xed effect regression results are reported based on the consideration that OLS regression estimators are biased upwards while xed 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 companys long-term debt to total asset ratio as the dependent variable and use the tangibility of a companys assets (TAN), its size (SIZE), its protability (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 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005

FE

FM

LSDVC 1997-2000 2001-2005

GMM-SYS 1997-2000 2001-2005

LT-Debt/TA

[t2 1]

TAN

SIZE

PROFIT

GROWTH

CONST

R2 F p IAS

0.57*** (9.65) 0.12** (2.40) 0.01** (2.25) 2 0.01 (2 0.12) 2 0.02* (2 1.71) 2 0.08 (2 0.66) 0.44 20.46 0.00 2.32 0.62*** (20.73) 0.10*** (3.27) 0.02*** (3.86) 2 0.14*** (2 3.15) 2 0.01 (2 1.50) 2 0.24*** (2 3.25) 0.68 74.08 0.00 2.67 0.02 (0.28) 0.08 (0.76) 20.01 (20.40) 0.04 (0.41) 20.01 (20.47) 0.31 (0.89) 0.01 0.20 0.96 1.02 0.34*** (8.21) 0.09 (1.13) 0.02 (1.00) 2 0.17*** (2 3.58) 2 0.03* (2 1.70) 2 0.22 (2 0.68) 0.62 18.83 0.00 1.51 0.57*** (12.10) 0.10 (1.48) 0.02 (1.73) 0.03 (0.32) 20.03* (23.00) 0.03 (0.12) 0.51 5.67 0.09 2.33 0.63*** (13.78) 0.10** (3.84) 0.02** (2.82) 20.07 (21.36) 20.02* (22.16) 20.13 (21.03) 0.72 6.32 0.04 2.69 0.40*** (4.50) 0.25* (1.86) 2 0.01 (2 0.31) 0.21 (1.47) 2 0.01 (2 0.50) n.a. n.a. n.a. n.a. n.a. 1.67 0.68*** (9.93) 0.01 (0.15) 0.05 (1.62) 20.09 (20.68) 0.01 (0.50) n.a. n.a. n.a. n.a. n.a. 3.08 0.54*** (4.05) 0.16 (1.32) 20.00 (20.02) 0.14 (1.13) 20.03 (21.56) 0.03 (0.12) n.a. 8.23 0.00 2.18

0.64*** (12.75) 0.02 (0.24) 0.02 (1.40) 2 0.23* (2 1.79) 2 0.00 (2 0.06) 2 0.20 (2 1.27) n.a. 71.45 0.00 2.81

Notes: * denote signicant levels at the 10 per cent level; ** denote signicant levels at the 5 per cent level; *** denote signicant 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 ordinary least square regressions, FE xed effect regressions, FM Fama-MacBeth regressions, LSDVC least square dummy variable corrected regressions, GMMSYS 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

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Table II. Regression results target adjustment dependent variable: LT-Debt/TA

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Even though the regression estimators for the other control variables included in the regression model are not directly comparable with those of other capital structure studies[11], they appear to be in line with the ndings in previous studies. That is, larger companies, those with lower growth opportunities and companies with lower prots borrow in general more than other companies. In respect to the target adjustment regression estimators, the results reported in Table II show in general a statistically signicant positive regression result for the LT-Debt/TA[t2 1] variable. Antoniou et al. (2008, p. 75) interpret this result as follows: The statistically signicant coefcient of the lagged dependent variable conrms that rms 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

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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 identied 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 identied 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

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simply document a signicant relationship between a companys current and past 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 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 identied, the results (IAS) of these robustness tests conrm 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 dened capital structure measures, such as a companys total liabilities to total asset ratio. As these results are de facto identical with those reported in Tables II and III we feel condent that our results are not inuenced by the denition 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 nancial 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 nancial 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 uctuations and nancial market changes are behind the identied capital structure changes. As the identication 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 companys 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

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OLS 1997-2000 2001-2005 1997-2000 2001-2005 1997-2000 2001-2005

FE

FM

LSDVC 1997-2000 2001-2005

GMM-SYS 1997-2000 2001-2005

LT-Debt/TA

[t-1]

TAN-TW

SIZE-TW

PROFIT-TW

GROWTH-TW

CONST

R2 F p IAS

0.59*** (10.18) 0.05 (1.38) 0.01** (2.03) 20.14** (22.15) 0.24 (1.52) 20.06 (20.48) 0.44 20.29 0.00 2.44 0.65*** (21.72) 0.00 (0.06) 0.02*** (4.56) 20.13*** (23.65) 0.05 (0.39) 20.18** (22.35) 0.67 69.65 0.00 2.85 0.02 (0.20) 0.11* (1.71) 20.04 (21.14) 0.09 (0.41) 20.09 (20.47) 0.61 (1.40) 0.07 0.83 0.53 1.02 0.35*** (8.59) 20.06 (21.17) 0.00 (0.03) 20.45*** (23.58) 0.20 (1.30) 0.25 (0.69) 0.47 17.47 0.00 1.55 0.60*** (27.55) 0.05** (3.29) 0.01 (1.30) 20.11** (23.18) 20.01 (20.04) 0.07 (0.36) 0.49 0.09 1.00 2.51 0.65*** (15.83) 0.01 (0.61) 0.02** (2.73) 2 0.12*** (2 6.40) 2 0.02 (2 0.11) 2 0.08 (2 0.69) 0.71 121.27 0.00 2.89 0.37*** (4.04) 0.19** (2.08) 20.06 (21.25) 0.29 (0.83) 20.06 (20.18) n.a. n.a. n.a. n.a. n.a. 1.59 0.65*** (9.64) 0.03 (0.56) 0.05 (1.24) 20.25* (21.72) 0.19 (1.23) n.a. n.a. n.a. n.a. n.a. 2.88 0.44*** (3.06) 0.11 (1.07) 0.03 (1.22) 0.01 (0.08) 20.15 (20.30) 20.38 (21.13) n.a. 8.56 0.00 1.77

0.67*** (10.33) 0.04 (1.33) 0.01 (1.01) 2 0.05 (2 0.75) 0.13 (0.85) 2 0.15 (2 1.18) n.a. 119.89 0.00 3.01

Notes: * denote signicant levels at the 10 per cent level; ** denote signicant levels at the 5 per cent level; *** denote signicant 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 ordinary least square regressions, FE xed effect regressions, FM Fama-MacBeth regressions, LSDVC least square dummy variable corrected regressions, GMMSYS 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 denitions 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

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Table III. Regression results target adjustment robustness tests Dependent variable: LT-Debt/TA

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adjustment studies have to come up with new ways for the identication and measurement of a companys 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 nancial market conditions.
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 companys 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 companys current capital structure and CS * is a companys target capital structure. it 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 companys current or its one year lagged capital structure target variable has no signicant inuence 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 companys 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 companys 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 xed 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 xed effect regression estimators are biased even if the number of cross-sectional units goes to innity. If, on the other hand, the number of time-periods increases, the bias of the xed effect regression estimator decreases. Monte Carlo simulations of Judson and Owen (1999) demonstrate however that the bias of the xed effect regression estimator in lagged dependent variable regression models remains signicant, 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).

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9. As can be identied, the regressions are run for the periods 1997-2000 (crisis period) and the 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 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 dened as a companys net property plant and equipment scaled by its total assets. A companys size is proxied by the natural logarithm of its total assets. The protability variable is dened as a companys return on total assets and the growth variable is a companys market to book ratio. 11. That is because they are the product of the adjustment speed and their own regression estimator. 12. Not reported signicance tests indicate that the adjustment speed measures for the period after the Asian crisis period are statistically signicant different from the adjustment speed measures during the years of the Asian crisis. 13. According to DMello and Farhat (2008) the average respectively moving average capital structure measures are the best available proxies for a companys target capital structure measure. 14. That is, in this robustness test a companys tangibility (TAN-TW) is calculated by the sum of a companys inventory and gross property, plant and equipment scaled by its total assets. The alternative size (SIZE-TW) gure is calculated as a three-year moving average gure of a companys logarithm of total assets. Similarly, a companys protability (PROFIT-TW) is calculated by its three-year moving average operating prot and the alternative growth measure (GROWTH-TW) is calculated by the quotient of a companys capital expenditures scaled by a companys 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 identied for other samples of companies (e.g. US, European, etc.) and investigation periods, which future research will have to prove. References Altman, E.I. (1984), A further empirical investigation of the bankruptcy cost question, Journal of Finance, Vol. 39 No. 4, pp. 1067-89. Antoniou, A., Guney, Y. and Paudyal, K. (2008), The determinants of capital structure: capital market-oriented versus bank-oriented institutions, Journal of Financial and Quantitative Analysis, Vol. 43 No. 1, pp. 59-92. Arellano, M. and Bond, S. (1991), Some tests of specication for panel data: Monte Carlo evidence and application to employment equations, Review of Economic Studies, Vol. 58 No. 194, pp. 277-97. Arellano, M. and Bover, O. (1995), Another look at the instrumental variable estimation of error-components models, Journal of Econometrics, Vol. 68 No. 1, pp. 29-51. Baltagi, B.H. (2005), Econometric Analysis of Panel Data, John Wiley & Sons, Chichester; Hoboken, NJ. Bancel, F. and Mittoo, U.R. (2004), Cross-country determinants of capital structure choice: a survey of European rms, Financial Management, Vol. 33 No. 4, pp. 103-32. Blundell, R. and Bond, S. (1998), Initial conditions and moment restrictions in dynamic panel data models, Journal of Econometrics, Vol. 87 No. 1, pp. 115-43.

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Petersen, M.A. (2007), Estimating standard errors in nance panel data sets: comparing approaches, Working Paper, Kellog School of Management, Northwestern University, Evanston, IL. Roodman, D. (2006), How to do xtabond2: an introduction to difference and system GMM in Stata, Working Paper No 103, Center for Global Development, Washington, DC. Scott, J.H. (1976), A theory of optimal capital structure, Bell Journal of Economics, Vol. 7 No. 1, pp. 33-54. Titman, S. and Wessels, R. (1989), The determinants of capital structure choice, Journal of Finance, Vol. 43 No. 1, pp. 1-19. Welch, I. (2004), Capital structure and stock returns, Journal of Political Economy, Vol. 112 No. 1, pp. 106-31. Windmeijer, F. (2005), A nite sample correction for the variance of linear efcient two-step GMM estimators, Journal of Econometrics, Vol. 126 No. 1, pp. 25-51. 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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