International Journal of Innovation, Creativity and Change. www.ijicc.

net
Volume 6, Issue 8, 2019

Sectorial-Specific Capital Structure

Determinants - Evidence from Bursa
Malaysia
Raja Rehana, Abdul Razak Abdul Hadib*, Hafezali Iqbal Hussainc,
a,b
Universiti Kuala Lumpur Business School, Malaysia. CTaylors Business
School (TBS), Taylors University Malaysia.
*Correspondence e-mail: b*[email protected],

This paper investigates the relevance of traditional and modern capital

structure theories in explaining capital structure determinants of listed
firms in Bursa Malaysia. Within the framework of Modigliani-Miller,
Trade-Off, Pecking-Order and Dynamic Capital Structure theories, this
paper employs Generalized Method of Moments (GMM) as an
estimation model on yearly panel data from 2005 through to 2016. The
test results from GMM show that Dynamic Capital Structure is the
most prominent among all, followed by the Trade-Off Theory.
Interestingly, current asset is the only determinant of capital structure
for the technology sector, implying the importance of asset quality in
this industry. Profitability is the most prevalent and significant
variable that determines the choice of capital structure in Plantation,
Industrial Products and Trading & Services sectors.

Key words: Modigliani-Miller Theory; Trade-Off Theory; Generalized Method of

Moments; Panel Data Analysis; Capital Structure Determinants.

Introduction

Malaysia used to be one of the ‘Asian tigers’ and its stock market was one of the highest
growth exchanges in Asia during 1990s. Today, the Malaysian economy is mostly driven by
its manufacturing, oil & gas and palm oil plantation sectors. The manufacturing, services and
mining sectors have been the engine room, supporting Malaysia economic growth since
1980s. Ever since, Malaysia has become a strong trading nation with a consistent record of
trade surpluses. The Asian Debt Crisis (1997-1998) was a real test pad for Malaysian policy
makers and businesses. The lessons learnt from this economic turbulence are a plenty. The
plantation sector was contributing the most during the early stage of the crisis. The crude

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Volume 6, Issue 8, 2019

palm oil (CPO) recorded higher prices and supported the demand for Ringgit (Malaysia
domestic currency).

Besides the plantation sector, the property and construction sectors subsequently came in to
turnaround the declining economic activities. Some drastic economic policies were
introduced by the central bank of Malaysia to increase money supply and consequently
stimulate aggregate demand. As a producer and exporter of crude oil, natural gas, and palm
oil, Malaysia's economy was once again put to test during the peak of the commodities crisis
in 2015. Net external demand pushed down the growth of Malaysia gross domestic products
(GDP) in the first half of 2015. During the third quarter of 2015, the Ringgit was the worst
performer against the U.S dollar among other Asian currencies. This volatile financial
scenario has triggered deep concerns over the need to diversify the Malaysia economy into
technology and services sectors. Like China, Malaysia adopts digital technology as the key
enabler to this economic transformation.

Business globalization and volatile regional financial markets have become a great challenge
to Malaysian companies in sustaining their growth, particularly in being continuously
competitive. The cost of financing has become one of the major hurdles not only for the
SMEs but also the public listed companies. Capital structure is regarded as one of the
important elements in corporate finance that helps contribute towards sustaining business
growth and maximizing firm’s value in the long run. The choice of financing will determine
the firm’s risk-return profile and directly provide risk exposure to the existing shareholders as
well as the stakeholders. In other words, managing a firm at optimal capital structure level is
a must on the condition that business growth is sustained while cost of financing is
minimized. However, financial managers need to be aware of the potential danger associated
with their choice of financing because each source of financing has its own individual
advantages and disadvantages which require special attention.

Many studies have been carried out around the world to investigate the theoretical link
between a firm’s capital structure and its performance as well as asset quality. This study is
unique in that it considers the seven critical sectors from Bursa Malaysia that have been
supporting Malaysian economic growth throughout the periods of recession and economic
boom. It is indeed important to understand the firm’s specific factors and their relationship
with overall structure of business financing. In general, companies from different sectors or
industries are characterized by different market dimensions, profitability and asset quality.
For this reason, it is important to find out what are the key factors behind Malaysia’s resilient
industries which are mostly funded by Bursa Malaysia, the Malaysian stock exchange
established in 1964.

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Literature Review

There are several significant capital structure theories that have emerged and caught the
attention of many scholars and researchers (Kovenock and Phillips, 1995; Kovenock and
Phillips, 1997). The traditional theory of capital structure tells us that wealth is not just
created through investments in assets that yield positive return on investment; purchasing
those assets with an optimal blend of equity and debt is just as important. This theory
believes that when the Weighted Average Cost of Capital (WACC) is minimized, then the
market values of assets are maximized. Subsequently, an optimal structure of capital will
resurface.

The modern theory of capital structure begins with the celebrated paper of Modigliani and
Miller. A firm’s capital structure is the relative proportions of debt, equity, and other
securities in financing its total assets. A business needs to plan its capital structure so as to
optimize the application of funds and in turn able to adjust easily to the changing
environments. Essentially, Modigliani and Miller hypothesize that in perfect markets, it does
not matter what capital structure that a company uses to finance its operations. They advocate
that the market value of a firm is determined by its earning power and the asset risk. The
basics of Modigliani and Miller proposition is based upon six key assumptions; (1) No taxes
(2) No transaction costs (3) No bankruptcy costs (4) Equivalence in borrowing costs for both
companies and investors (5) Symmetry of market information, meaning that both companies
and investors have the same set of information (6) No effect of debt on a company's earnings
before interest and taxes.

Besides Modigliani and Miller theory, the Trade-Off theory is another celebrated capital
structure theory which is still relevant today. The theory simply explains that any company
will select a preferred mix of debt and equity financing by balancing out their individual costs
and benefits. This theory is also known as a Static Theory and it assumes that companies will
benefit from their leverage activities within a capital structure until the optimum capital
structure is achieved. The theory acknowledges the tax advantage derived from interest
payments but the risks associated with leverage are translated into bankruptcy and agency
costs.

The relationship between capital structure and company performance is still debatable as
many previous studies have concluded diverse findings. Some of the studies find that there is
a significant negative relationship between leverage and the firm’s performance (Krishnan
and Moyer, 1997; Zeitun and Tian, 2007). Similar finding has been observed in several
countries as conducted by other researchers (Brigham & Gapenski, 1996; Majumdar and
Chhibber, 1997; Rao, Al-Yahyaee and Syed, 2007). Specifically, Gleason, Mathur and
Mathur (2000) have found negative relationship between firm’s performance and different

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Volume 6, Issue 8, 2019

types of combination in capital structure. The issue of understanding the relationship between
the firm’s performance and different combination in capital structure has been associated
with the changes in economic conditions, especially during Asian financial crisis in 1997
(Tan, 2012). His study points out that the negative relationship between the firm’s
performance and the financial risk stems from excessive leverage before the time of financial
crisis.

Interestingly, there are earlier studies that indicate different direction of the relationship
between the firm’s performance and financial leverage. Most of these studies point out that
financial leverage would contribute positively towards improving the performance of the
firms as reflected in the increase of productivity level, which in turn enhance the firm’s
profitability over time (Huyghebaert, 2006; Titman and Wessels, 1998; Myers, 2001; Ross,
1977; Noe, 1988). Some previous studies have also confirmed similar results that firm’s
value has been positively influenced by certain mix of capital structure which is closer to the
optimum level (Maksimovic, Stomper and Zechner, 1999; Barclay, Smith and Watts, 1995).
Technically, an optimum capital structure is an ideal point where firms are able to minimize
their overall cost of financing coupled with maximization of firm’s value (Hadlock & James,
2002; Corriceli, Driffield, Pal, and Roland,2011). Leverage or debt financing does exert
some positive influence on increasing the firm’s value since profitability is the key enabler
for firm’s long run financial sustainability and growth (Roden and Lewellen, 1995; Sharma,
2006; Ehrhardt and Brigham, 2006)

Data and Methodology

This study focuses on seven sectors at Bursa Malaysia as shown in Table 1 below. The raw
data are extracted from Bloomberg and the yearly panel data are analyzed from 2005 through
2016. There are seven variables to be scrutinized in this study namely; debt-equity ratio, total
assets, fixed assets, current assets, sales, return on equity and earnings per share. In analyzing
the panel data, SAS program is deployed.

Table 1: Seven Sectors at Bursa Malaysia

No. Sector Market Category
1 Consumer Products Main Market
2 Industrial Products Main Market
3 Construction Main Market
4 Property Main Market
5 Plantation Main Market
6 Technology Main Market
7 Trading and Services Main Market

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Generalized Method of Moments (GMM) is mobilized as an estimation model for testing the
determinants of a firm’s capital structure across the seven sectors. This method provides the
panel data with efficient econometric estimators. GMM is a dynamic estimation model that
embraces panel data and capable of reducing and easing up the endogeneity problem.
Endogeneity is the correlation between the parameters or variables with the error term. This
GMM approach controls the endogeneity problem by employing unobservable shocks in the
cross-sectional component. To ensure the validity of GMM results, two important diagnostic
tests are performed – serial correlation test on the error terms and the test for exogeneity of
the instruments via Sargan test. The GMM procedure is summarized in Figure 1 below. The
GMM approach is commendable because it improves estimation efficiency by reducing the
multicollinearity problem and increasing the degree of freedom between the explanatory
variables. Also, GMM embraces panel data approach that yields the advantage of solving
unobserved firm-specific effects. In short, GMM is a method that alleviates the deformation
caused by fixed effects, simultaneity and endogeneity. The study applies the GMM approach
that considers both dimensions of cross-sectional and time-series data.

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Figure 1. Generalized Method of Moments (Process and Procedure).

First differences GMM

(Generalized method of
moments)

Test for exogenelty of

instrument (Sargan test)
Chi-squared distribution

Non-existence of the serial

Correlation (AR1)

The instruments used in the The instruments used in the

GMM estimation are valid GMM estimation are not valid

Weak model or the model is

Strong model
mis-specified

Testing the determinants of

firm’s capital structure and
validity of some capital
structure theories

In addressing the problem of endogeneity, involving independent and explanatory variables, a

two-step GMM method is used to control the correlation error over time, that is, mitigating
the effect of orthogonality conditions on errors, and heteroskedasticity across firms. Observed
and unobserved firm-specific determinants determine the optimal capital structure. These
firm and time specifics do changes on capital structure and the optimal leverage point.
Depending on the determinants of capital structure, the following GMM model is developed:

Y*it= 0 + ∑k βk Ҳkit +i+t+it ……………. (1)

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Where: Y* = the dependent variable

i=1,….., N.
Firm-specific characteristics are measured by ∑k βk Ҳkit, and the result varies from time to
time and from firm to other.
αi is the unobserved firm- specific effect,
αt captures the time effect.

The lagged values of the dependent variable of the GMM model are examined to evaluate the
consistency and the validity of the other explanatory variables. The error terms must not
exhibit any serial correlation. Serial correlation is often observed in time series data, but not
in cross-section. Due to this limitation, the panel data approach is recommended. In order to
avoid the problem of serial correlation, the first and second order serial correlation test is
conducted. The AR1 and AR2 must provide a negative significant results and no evidence of
second order autocorrelation. The error is assumed to be independent of its past and it has no
memory of its past values.

The Sargan test (1958) is proposed by John Denis Sargan and occasionally referred to as the
Hansen test or J-test. It is used to examine the exogeneity of the instruments and their
consistency. It is aimed at exploring variables and finding out whether they are uncorrelated
to some sets of residual. If the Sargan test is not valid, the model is classified as weak. The
degrees of freedom are found by calculating the difference between the number of
instruments and the number of regressors. The GMM is used to generate consistent and
efficient estimators of the parameters in this study.

Empirical Findings

The empirical findings of this study are summarized in Table 2 below. Specifically, Table 2
demonstrates the parameter estimates and their level of significance for the first three sectors
– Property, Construction and Industrial Products. Looking at the lagged dependent variable
across the three sectors, it is clear that the Dynamic Capital Structure does exist with their
individual speed of adjustment moving towards the target capital structure at relatively fast
pace ranging between 0.20 and 0.39. It is interesting to note that tangibility (as measured by
TA, FA, and CA) shows a consistently positive significant relationship with firm’s leverage.
This positive relationship is expected because any increase in the value of assets will entice
firms to take up more debt. Sales and profitability (as measured by ROE and EPS) seem to
be a significant determinant of capital structure for Construction and Industrial Products
sector respectively.

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Table 2: Dynamic GMM Analysis across Property, Construction and Industrial Products
Sectors
Sector Property Construction Industrial Products
Variable Estimate P-value Estimate P-value Estimate P-value
Intercept 0.0035 0.9314 -0.0569 0.0002 -0.0570 0.0002
lde_1 0.2412 0.0082** 0.3970 0.0001** 0.1978 0.0118**
ltasset 0.4057 0.3508 1.1823 0.0004** 0.9146 0.0210**
lfasset 0.3675 0.0001** 0.1465 0.0051** 0.1060 0.0001**
Lca 0.2382 0.4486 0.3324 0.0002** 0.3187 0.3390
lsales -0.1283 0.1027 -0.2725 0.0005** 0.2208 0.1092
Lroe -0.0927 0.5083 0.0101 0.8731 0.3501 0.0094**
Leps -0.0729 0.5617 -0.0142 0.8517 -0.3106 0.0320**
**significant at 5%*

Table 3 presents the parameter estimates of four more sectors of Bursa Malaysia namely,
Technology, Trading & Services, Consumer Products and Plantation sectors. The capital
structure behaviour of these four sectors does not vary much as compared to the first three
sectors. The Dynamic Capital Structure theory is still dominant across these four sectors as
their individual speed of adjustment moves at even a faster pace, ranging between 0.20 and
0.58. Needless to say, this target capital structure approach does exist across these seven
sectors and in line with the results of earlier studies by Haron and Ibrahim (2012) and Ting
(2016).

As a traditional determinant of capital structure, tangibility still holds significant explanatory

power over capital structure variations of these four sectors. This finding confirms the work
of Wahab and Ramli (2014). Lastly, it is worthwhile to note that there is a significant
negative relationship between EPS and firm’s leverage at plantation sector. This finding is
consistent with the study of Ling and Lean (2011) suggesting that any significant
improvement in firm’s profitability will undoubtedly reduce its dependency on borrowings.

Table 3: Dynamic GMM Analysis across, Technology, Trading & Services, Consumer
Products and Plantation Sectors
Sector Technology Trading & Services Consumer Products Plantation
Variable Estimate P-Value Estimate P-Value Estimate P-Value Estimate P-Value
Intercept -0.2506 0.0054 -0.0371 0.0705 -0.0819 0.0001 -0.0314 0.0001
lde_1 0.3835 0.0523* 0.2547 0.0017* 0.2020 0.0062* 0.5794 0.0001*
* * *
Ltasset 1.5594 0.1439 1.0393 0.0001* -0.2690 0.4901 0.3100 0.0170*
* *

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Lfasset 0.3597 0.1346 -0.3196 0.0009* 0.5211 0.0001* 0.0351 0.1535

* *
Lca 1.1056 0.0054** -0.2792 0.1501 1.3431 0.0001* 0.0888 0.0001*
* *
Lsales -0.0162 0.9630 0.2319 0.1134 -0.0187 0.8749 0.0497 0.4426
Lroe -0.0601 0.8446 0.2097 0.0053 0.1342 0.4563 0.0402 0.5362
Leps 0.2480 0.4516 -0.0377 0.2734 -0.2000 0.1505 -0.1232 0.0211*
*
**significant at 5%, *significant at 10%

Technically, the estimated models in this study are free from any diagnostic issues. From
Table 4, we can see that the null hypothesis of correct model specification and absence of
autocorrelation from respective Sargan test and the AR(m) test cannot be rejected at all (see
the p-value). These test results strongly support that those dynamic panel data models are
correctly specified and therefore the parameter estimates are valid.

Table 4: GMM’s Diagnostic Tests

Diagnostic Test Property Construction Industrial Technology Trading Consumer Plantation
Products & Products
Services
Sargan Test 0.6986 0.7309 0.7868 0.9998 0.7802 0.5434 0.5920
(Prob >ChiSq)
AR(m) Test 0.8710 0.6647 0.9998 0.2283 0.9855 0.9955 0.9941
(Prob>Statistic
Number of 46 27 127 17 102 80 36
cross sections

Conclusion

Despite the puzzle surrounding the mixed results of capital structure studies around the
world, this paper strives to provide an in-depth understanding on the relationship between
Malaysian firm-specific variables and their debt-to-equity mix. This paper investigates the
relevance of classic and modern capital structure theories in explaining capital structure
determinants of listed firms at Bursa Malaysia. Within the framework of Modigliani-Miller,
Trade-Off, Pecking-Order and Dynamic Capital Structure theories, this study employs
Dynamic Generalized Method of Moments (GMM) as an estimation model on yearly panel
data from 2005 through to 2016. The test results from GMM show that Dynamic Capital
Structure is the most prominent among all, followed by the Trade-Off Theory. Interestingly,
current asset is the only significant determinant of capital structure for the technology sector,
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Volume 6, Issue 8, 2019

implying the importance of asset quality in this industry. Profitability is the most prevalent
and significant variable that determines the choice of capital structure in Plantation, Industrial
Products and Trading & Services sectors.

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