Letter of Transmittal

July, 2011

Mr. Dilip Kumar Sen

Lecturer, School of Business

Independent University, Bangladesh (IUB)

Dhaka.

Subject: Submission of the Article Interpretation report.

Dear Sir,

With due respect, I would like to inform you that, it is a great pleasure for me to submit the

Article Interpretation on “The Pecking Order Theory: Evidence from Manufacturing Firms

in Indonesia”, as a requirement for MBA 511 program. While conducting the working report, I

have gathered lots of knowledge on Capital structure and the implication of pecking order theory

vs. Trade off theory in Indonesian manufacturing firms.

Sincerely Yours

………………………….

Md. Azam Khan

ID# 0711050

Executive Summary

A fundamental issue in corporate financing is to understand how firms choose their capital

structure in the course of their operations. The main 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 panels of 18 manufacturing companies taken from the

Indonesian Stock exchange main board companies. The research findings reported in this paper

provide further substantial evidence broadly describing pecking order financing behavior

amongst the manufacturing companies.

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 is to understand 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 firm’s 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 firm’s 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, although

dividends 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 investment

opportunities, 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.

If external finance is required, firms issue the safest security first. That is, they start with

debt, 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 firm’s 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 of capital structure in Indonesian firms in manufacturing sector.

Theme of the study

The pecking order theory is from Myers (1984) and Myers and Majluf (1984). Since it is well

known, 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

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 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.

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 1994 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 to 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.

Serial 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

+ e deficit + f tangibility + u

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

+ 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:

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.

Profitability: Profitability has a negative relation to debt ratios.

Size: Size has a positive relation with long term debt and negative relation with short

term debt.

Tangibility: Asset tangibility has positive relation with long term debt ratio and negative

relation with short term debt ratio.

Results of regression of equation 1, 2 & 3

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%

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.

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. 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.

Results of Regression of equation 6

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.

Results of Regression of equation 7

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.

Results of Regression of equation 8

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 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?

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. 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

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 Peckign 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.

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