Advances in Economics, Business and Management Research, volume 123

1st International Conference on Accounting, Management and Entrepreneurship (ICAMER 2019)

Examining the Firm Value Based on Signaling

Theory

Acep Komara*, Imam Ghozali, Indira Januarti

Department of Accounting
Faculty of Economics
Swadaya Gunung Jati University
Cirebon, Indonesia
*[email protected]

Abstract—The value of the company is an important factor order and agency cost theories, that there is a link between the
considered by the company to create increased prosperity of leverage levels of firm value [8].
shareholders. With the increase in the value of the company
reflected in the price book value, it will give a positive perception The influences of profitability and leverage on firm value
of the investor on the invested investment. Therefore, this article became a factor considered in financial decision making [9].
aims was to analyse the value of the company based on the Efforts in maximizing company value and shareholder wealth
company size, profitability, and debt level. This study was are carried out by choosing the most efficient investment. The
conducted on the Trading Sector Company of Production Goods plan is considered so that the company can survive and thrive
and Retail Goods listed on the Indonesia Stock Exchange period in the face of a highly competitive environment. If the
2014-2016. Based on the purposive sampling method obtained company needs financial aspects, then the company can choose
158 company data as samples. Data Analysis Techniques Use between internal and external funds. If the company uses
regression analysis that begins with a classic assumption test. internal funding sources, it will reduce the amount of cash
Hypothesis testing was conducted through T-Test, and the results stock. Whereas if the company does debt, it increases the risk
showed that the company's size was positively influential towards of the debt. Capital structure and profitability are considered
the company's value, while profitability and debt levels did not contributing in influencing the company's shares. Debt issuance
affect the company's value. in the presence of excess cash flow may convey positive signal
to the market which is/replicated by an increase in firm value
Keywords: debt level, firm value, size, profitability
[10].
I. INTRODUCTION Various studies analyse firm value through several factors
that are considered important effect. Ghosh analysed the role of
One of the goals of the company is to maximize the welfare leverage and profitability on the future value of the firm for an
of shareholder, therefore the company must seriously make emerging economy, India [11]. The study proved that there is a
efforts to achieve that goal [1-3]. Shareholder welfare relates to non-linear relation between leverage, profitability and
the company's market value, which became the most important probability of increase in future value of the firm. Probability
measurement [1]. The company's assessment became essential of increase in future value of firm reduces exponentially with
for deriving stock prices, which became an important item in the increase in leverage, whereas, it increases with the raise in
various models [2]. The firm value is determined based on the dividend pay-out and profitability of the firm. Profitability is
firmware's asset earning power [4]. If the company has higher undoubtedly one of the major factors determining the firm
earning powers of the company, it has a positive impact on value.
greater profit and more efficient company assets. Therefore, the
value of the company has increased. In addition to assets and The influences of profitability and leverage on firm value
profits, the company's debt policy also affects the company's became a factor considered / confirmed that profitability has a
value. The higher the debt, the higher the share price. positive effect on firm value [9]. But on the other hand, when
investors consider the influence of profitability on firm value,
Consideration of the importance of corporate financial they are more focus on leverage's negative effect on the firm
decisions to the firm value is disputed [5]. Some factors that value. High level of debt may cancel the positive effect of
influence firm value, profitability and leverage. Decisions profitability on firm value. The study also showed that the size
regarding dividend decisions as well as decision of capital of the firm has no significant effect on firm value. The leverage
structure are chosen according to the benefits given. The positively affects the value of firms without growth
company's debts provide benefits to tax gains that can increase opportunities [5]. Obradovich and Gill analysed 333 firms
the firm's value. Exchanges of debt for equity produce higher listed on New York Stock Exchange (NYSE) for a period of 3
stock prices [6], while exchanges of equity for debt lower stock years from 2009-2011 [1]. The results show that financial
prices [7]. Higher financial leverage decrease firm value by leverage, firm size and return on assets positively impact the
increasing bankruptcy risk [1]. Fosu et al emphasized on Duck value of American firms. Supported by Sucuahi and

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 Advances in Economics, Business and Management Research, volume 123

Cambarihan which analyses profitability with the firm value influence on firm value [4]. A perfect capital market does not
using Tobin's Q model [3]. 86 diversified companies in the have corporate tax or transaction costs, and when information
Philippines analysed through multiple regression. The results asymmetry is not a concern, a firm’s value is determined by its
proved that profitability shows significant positive impact on ability to create value, no matter whether the capital it uses is
the firmware's value. from internal or external sources. The MM model fails to
predict it because it considers only the tax saving effect of debt
Fosu et al analysed the UK firms and the study defined that and ignores the cost of financial risk and agency cost when
leverage has a negative effect on firm value [8]. Adetunji debt increases.
analyses the relationship between financial leverage and firms '
value, as well as evaluate the effect of financial leverage on Zingales and Rajan found that large firms are more
firms ' value [2]. A sample of 5 firms listed on Nigerian Stock diversified than small ones, and face lower risk [16]. In
Exchange (NSE) for a period of 6 years from 2007-2012 was addition, large firms have a low bankruptcy cost and are well
used. The study proved that financial leverage has significant known, which makes it easier to enter the stock market. When
effect on firms ' value. The study concludes that financial firms have the same profitability, the larger firm will have a
leverage is a better source of finance than equity to firms when relatively low level of debt [9]. Myers and Majluf pointed out
there is need to finance long-term projects. However, the use of that the problem of formation asymmetry is not as severe in big
debt financing in such firms may yield negative impact such as firms, and the information cost is also lower than for small
bankruptcy as well as low firm value. firms [17]. Moreover, large firms prefer to use equity capital
rather than debt capital, with Titman [18] arguing that small
Sunday [12] indicates that the higher financial leverage firms rely on the former because they have to face a high issue
decrease firm value by increasing bankruptcy risk. Therefore, cost. Therefore, larger companies have access to obtain funding
an optimal capital structure is necessary for every firm to from equity capital. The company's ability is a positive signal
enhance the market value the firm [13]. An optimal capital for investors to invest and will have an impact on firm value.
structure includes some debt, but not 100% debt. It is a ' best ' Previous studies have shown that firm size has a positive effect
debt/equity ratio for the firm that minimizes the cost of on firm value. Based on this explanation, the hypothesis
financing and reduces the chances of bankruptcy. Cuong and proposed is:
Canh found that the optimal debt ratio should not exceed
59.27% because a higher debt ratio will have negative H1: firm size has a positive effect on firm value
highlights on firm value [14]. Financial leverage plays an
important role in increasing market value of the firm [13]. A. Profitability and Firm Value
The phenomenon of firm values that have been tested on Chen and Chen prove that the amount of earnings given to
companies in different countries shows different results. The shareholders can increase firm value [9]. Profitability
company's decision to determine the policy on capital structure measurement is based on return on assets owned by the
and company characteristics is considered as a factor that company. Return on assets shows the efficiency of
provides signals for shareholder in investment decisions. management in managing its assets, as well as being a positive
Therefore, the study aims to analyse firm size, profitability and measurement in determining firm value. Ghosh analyses the
debt level rake to predict the value of the company based on role of profitability on the future value of the firm for an
the perspective of signalling theory. The significance of this emerging economy, India [11]. The study proves that
research to expand the knowledge specifically in management probability can increase future value of the firm. Based on this
accounting field. explanation, the hypothesis proposed is:
Ross explain that the signalling model is related to activity H2: Profitability has a positive effect on firm value
choice by the manager [15]. Signalling Theory states that the
manager or the company qualitatively has an information B. Leverage and Firm Value
compared to outside parties and they use the certain sizes or Adetunji emphasizes that in fulfilling funding for
facilities imply the quality of its company. At least there are operational and corporate activities, managers have a motive so
four types of signal theory known in financial literature, that these decisions can bring benefits and can maximize the
namely 1) model signal maturity options debt, 2) the company's welfare of the owner [2]. The company has various alternative
investment signal model, 3) signal model financial structure, sources of funding to fund its investment. There are two
and 4) the dividend signal model. Each model has an own categories, namely the internal financing sources which include
consequences for both managers and shareholders, (investor) or reserves and retained earnings; external financing which
a treasury holder. Shareholders or investors must use any includes long-term loans, bond issues, ordinary and preferred
understanding to suspect the possibility of the signals being stock issues. To achieve an optimal capital structure,
signalled by the manager. If shareholders or investors do not companies must be able to choose financial decisions that can
attempt to seek information related to the signals, they will not have positive returns. Financial leverage is the extent to which
be able to take advantage. So, any signal that the value of the fixed income securities (debt) are used in a firm's capital
company should be carefully examined. structure. Despite the initial statement of Modigliani and Miller
Modigliani and Miller proposed the capital structure [4] that there is no connection between leverage and firm value.
irrelevance theory, which states that under the assumption of a In 1963, the study examined the influence of the tax on firm
perfect capital market, the choice of bonds or stocks makes no value into consideration, they revised this opinion and stated
difference to firm value; in other words, capital structure has no that issuing debt can help to increase firm value.

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 Advances in Economics, Business and Management Research, volume 123

That corporate debt plays a role in determining firm value A. The Effect of Firm Size on Firm Value
[5]. Strengthened by Myers stresses the negative effects of too The results of hypothesis testing prove that company size
much corporate debt on firm value, as it may motivate has a positive effect on firm value with a significance value of
managers to forego profitable investment projects [19]. 0.041 and a regression coefficient value of 0.108. These results
Because of bondholders' priority over the firm's cash flow are consistent with [9,11] that company size has a positive
relative to shareholders, managers could forego projects with effect on firm value. The size of the company that is reflected
positive net present value if the project's earnings go to the in the value of total assets shows the size of assets and asset
creditors [20]. Thus, we could expect a negative relationship management which is considered a positive signal for investors
between debt and firm value in the presence of growth towards managing company assets. In accordance with
opportunities. Based on this explanation, the hypothesis signalling theory, that information about assets provided by
proposed is: management can be used as a benchmark in investment
H3: Debt level has a negative effect on firm value decision making. The greater the size of the company, the more
investor confidence increases and is reflected in the increase in
the value of the company.
II. RESEARCH METHODOLOGY
This study predicts the value of the firm based on firm size, B. The Effect of Profitability on Firm Value
profitability and debt levels. While firm value is the dependent
The results of hypothesis testing prove that profitability has
variable, while firm size, profitability and debt level are
no effect on firm value with a significance value of 0.628 and a
independent variables. Company data that are sampled come
regression coefficient value of 0.038. These results are not
from 158 companies trading in manufactured goods and retail
goods listed on the Indonesia Stock Exchange in the period consistent with [9,11].
2014-2016. The following is the operationalization of variables Profitability shows the company's ability to generate
in this study: profits. Based on the profitability data of the sample
companies, the majority of the company's profitability has
Firm size (X1) is measured by the logarithm of the total
decreased, but the amount is not significant. Therefore, a small
assets. Profitability (X2), measured based on return of assets
change in profitability does not have an impact on increasing
(the return of assets equals the ratio of earnings before interests
the value of the company. In accordance with the signalling
and taxes on total assets) the measurement was adopted from
theory that profitability reflects information and signals
Zingales and Rajan [16]. Leverage (X3) is measured based on
regarding the company's prospects in the future.
two measures for the leverage; one is the debt-equity ratio,
which stands for the ratio of liabilities to shareholders' equity,
while the other is the liability capitalization ratio, which stands C. The Effect of Debt Level on Firm Value
for the ratio of liabilities to capital. Firm value (Y) is measured The results of hypothesis testing prove that debt level has
based on market value, and this is defined as the stock price per no effect on firm value with a significance value of 0.691 and a
share at the end of the year. regression coefficient value of 0.051. These results are not
consistent with [8,13,14].
Data analysis techniques in this study use multiple
regression analysis to predict the effect of firm size, Debt level reflected in leverage shows the portion of capital
profitability and debt levels on firm value. Hypothesis testing structure owned by the company, consisting of internal funding
in this study uses partial test. sources and external funding sources. Debt level is obtained by
the company through debt issuance. Based on the debt level
III. RESULTS AND DISCUSSION data on the sample company, the majority of the company's
debt level has increased, but not significantly. Therefore, the
The following table results in multiple regression analysis increase in debt level has no effect on changes in the value of
in this study: the company. According to the signalling theory, that the high
value of the company's debt indicates negative information for
TABLE I. MULTIPLE REGRESSION ANALYSIS the company. But insignificant changes in debt have no impact
on declining company values
Variable Coefficient Sig.
Constant -2.373 .084
Size (X1) .108 .041 IV. CONCLUSION AND RECOMMENDATION
Profit (X2) .038 .628
The results showed that firm size has an effect on firm
Debt (X3) .051 .691
value, while profitability and debt level have no effect on firm
Source: secondary data processed, 2019
value. This indicates that an increased firm size can provide a
Based on the results of regression analysis, the regression positive perception for investors in making investment
equation in this study is: decisions. While profitability and debt levels have no effect on
firm value. Therefore, company management is expected to be
VALUE = -2,373 + 0,108SIZE + 0,038PROFIT + 0,051DEBT + e able to manage profitability optimally, as well as pay off debt
Hypothesis testing is done through the t test and the results decisions by considering the optimal capital structure. Future
show that firm size has a positive effect on firm value, while research is expected to further emphasize other factors that can
profitability and debt levels do not affect firm value. increase the value of the company, such as earning per share.

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