Paper FMI Risal Rinofah Irwan Trinugroho

DOES MISPRICING AFFECT INVESTMENT AND CAPITAL STRUCTURE OF INDONESIAN FIRMS?

Risal Rinofaha, Irwan Trinugroho b1

a Alumni of Master of Science in Management, Gadjah Mada University

Jl. Nusantara, Kampus Bulaksumur, Yogyakarta, Indonesia 55281

b Faculty of Economics, Sebelas Maret University

Jl. Ir. Sutami No. 36 A, Surakarta, Indonesia 57126

1 Corresponding author +62274868298, +62271668765

Email addresses: [email protected], [email protected]

ABSTRACT

Stock price movement is not entirely a reflection of its fundamental value

because of there are non-fundamental factors such as market sentiment (Keynes,

1936), behavioral biases of investors (Lakonishok et al., 1994), systematic errors

when assessing stock (Stein, 1996), asymmetric information (Tobin, 1969)

causing the value of stock deviate from its fundamental value (misprice). This

condition can affect corporate investment decisions because managers can take

advantage of overvalued stock condition as a source of investment funding

because the cost of capital becomes cheaper. Conversely, firms avoid selling

stocks at undervalued due to high cost of capital. Therefore, the objectives of this

research is to examine the effect of mispricing to firms investment behavior and to

firms capital structure. We also test the role of the level of financial constraint in

the relationship between mispricing and investment.

Using panel data regression with data observation for five years, we find

that mispricing have positif impact to firms investment level. However, this effect

is not diverse whether on a group of firms which have a high level of financial

constraint (financially constraint) or those which have a low level of financial

constraint (less constraint). Moreover, this research also find that the mispricing

can also influence firms in choosing sources of funding which can be seen on their

debt to equity ratio (D/E). To check the accuracy of examination, we employ

some robustness test and use several control variables. These results are consistent

with and can be explained using market timing and catering hypotesis.

Keywords: Mispricing, investment, capital structure, financial constraint, market

timing hypothesis, catering hypothesis

A. INTRODUCTION

Capital markets play an important role for firms, Wang et al. (2008)

explain that one of the important functions of capital market for firms is as a

medium to obtain funding sources. When the market condition is efficient, value

of stock will fully reflect the fundamentals of firm (Wang et al, 2008). But, in

fact, stock price movement is not entirely a reflection of its fundamental value

because of there are non-fundamental factors such as market sentiment (Keynes,

1936), behavioral biases of investors (Lakonishok et al., 1994), systematic errors

when assessing stock (Stein, 1996), asymmetric information (Tobin, 1969)

causing the value of stock deviate from its fundamental value (misprice). This

condition can affect corporate investment decisions because managers can take

advantage of overvalued stock condition as a source of investment funding

because the cost of capital becomes cheaper.

This condition can affect investment decisions because managers can take

advantage of the overvalued stock as a source of investment funding because the

cost of capital becomes cheaper. Conversely, avoid selling stocks at undervalued

because of the cost of capital is high. For high financial constraint firms, that

concentrate on stock as source of funding, this condition will affect investment

decision. Instead, for low financial constraint firms, the value of stock will not

affect their investment decisions because of the availability of adequate funding

sources. The sensitivity difference is known as the equity financing channel

(Stein, 1996).

The examination of the relationship between investment, mispricing and

finacial constraints in various combinations have been done especially in the US

(eg, Polk and Sapienza, 2002; Baker et al, 2003; Chang et al, 2007). Polk and

Sapienza (2004) find that overvalued (undervalued) firms tend to overinvest

(underinvest). Overvalued firms tend to accept project with negative net present

value (NPV), consequences of excess sources of funding. While, the undervalued

firms tend to reject project that has positive NPV because of the limitation of

funding. Baker et al. (2003) conducted research in the US using 52,101

observations find that stock price movements in the capital market are able to

influence investment more strongly to firms with high financing constraint than

low financing constraint firms.

Wang et al. (2008) explain that differences in social system, the structure

of microeconomics, economic development stage and the structure of financial

markets in different countries can lead to differences in the relationship between

stock market and investment. This is evidenced by their research in China that

find no significant response from the policy of investment to assess the market

share. Therefore, doing similar research in developing countries - different

characteristics with the US and others develop countries - such as Indonesia is

expected to give a broader understanding of the relationship between stock market

and investment conditions of different countries

B. LITERATURE REVIEW AND HYPOTHESES

1. Mispricing and Investment

Mispricing is defined as a condition in which the value of stock in the

capital market different from its fundamental value. Some causes of the

mispricing are the presence of asymmetric information between manager and

investor, as well as the bias of investor assessment (Alzahrani, 2006). Bias in

assessment is an element of investors irrationality when making an assessment of

a stock (Keynes, 1936). Sadka and Scherbina (2007) find that the mispricing can

also arise due to disagreements among the analysts associated with transaction

costs or the liquidity of the stock. The relationship between stock prices and

firm’s investment have a lot of attention since the recognizing that the two

variables have a very close relationship. This is based on two theoretical

explanations which states that: first, the stock prices reflect information about the

firm’s fundamental factors and therefore the fundamental condition of the firm is

a factor that affect investment decision. The second explanation, the firm may be

experiencing financial constraint, which may hamper the firm to achieve an

optimal investment plan so that the increase in the stock price is expected to be a

cheaper source of funding to be used as a targeted investment fund (Chen et al,

2005).

Market-Timing Hypothesis

A manager will take advantage of mispricing by issuing overvalued stocks

to enjoy lower capital costs and otherwise, avoid issuing undervalued stocks to

avoid high capital costs. The existence of this opportunity will encourage

managers to implement investment plans. Instead, managers of undervalued firms

will avoid to issuing stock, even if they need it, because of the high cost of capital

in undervalued stocks. In other word, overpricing tends to make increasing

investment opportunity and vice versa, underpricing tends to reduce the

opportunities for investment.

Catering Hypothesis

A manager will try to please the wishes of the investors because they want

to maintain their "reputation" (Holmstrom, 1999), and maximize their based on

stock price compensation. As a result, when the firm's stock is overvalued,

managers will try to increase investment to encourage the further

overvaluation. While, managers with undervalued stock tend to reduce the

investment to avoid the further undervaluation.

Based on the theory and previous research, the first hypothesis is as

follows:

H1: Mispricing has positive effect on investment

2. The Effect of Financial Constraints on the Relationship between

Mispricing and Investment

The term financial constraints which was introduced by Fazzari et al.

(1988) basically have the same term with equity dependency (Stein, 1996, Dong

et al., 2007), both of them describe the condition of the firm facing difficulties to

seek sources of funding. High financial constraint firm is characterized by

inadequacy of internal funds (eg, cash and retained earnings) and the difficulty in

obtaining external capital in the form of debt. This situation makes the firm rely

on selling of stocks to fund its investments (Baker et al, 2003). (Stein 1996, Dong

et al., 2007) call this condition in terms of equity-dependent. Conversely, firms

that do not experiencing this problem called as low financial constraints or non-

equity dependent. Kaplan and Zingales (1997) state that funding constraints could

result from differences in capital costs from internal resources and external

resources. For firms with low financial constraints, they do not rely on stock, so

the condition of mispricing (overvalued or undervalued) will not affect their

investment decisions. In contrast, investment decisions of high financing

constraint firms may be more sensitive to the value of its stock. From this theory,

it can then be concluded that the level of funding constraints may affect the

sensitivity of the effect of mispricing on investment.

Then, the second hypothesis formulated as follows:

H2: The Sensitivity of the effect of mispricing on investment in firms with

high financial constraints is greater than firms with low financing

constraints

3. Mispricing and Capital Structure

Research conducted by Hovakimian et al. (2001) find that the tendency to

sell stocks when the condition is overvalued can be used to pay off some debt to

achieve the desired leverage condition. Firms that tend to sell stocks when the

overvalued stock market value will make the debt-equity ratio become lower.

Instead, if the firm will not sell stock when the condition is undervalued and

choose another funding source that is cheaper or with other considerations (for

example, prefer debt) will make the debt-equity ratio becomes higher. At the same

time, the increasing of equity due to overvalued condition can also be

accompanied by a significant deterioration in debt.

Then, the second hypothesis formulated as follows:

H3: The higher (positive) level of mispricing, the lower the debt-equity ratio,

the lower (negative) level of mispricing, the higher the debt-equity ratio.

15141312110 −−−−− +++++= ttttt DPRROAROEPEREPS βββββα

εββ +++ −− 1716 tt PFCFPS

C. RESEARCH METHODS

This study used the data during 2003-2007 obtained from the OSIRIS

database, financial reports and stock trading data. Samples are all manufacturing

companies listed in Indonesia Stock Exchange (IDX), which amounted to 142

companies (Indonesian Capital Market Directory, 2007).

1. Proxy of Mispricing

In several previous studies (Dong et al, 2003; Bloomfield and Michaely,

2004; Bartov and Kim, 2004; Baker and Wugler, 2002), mispricing proxy that be

used is the actual value of market-to-book. This is different from the methods

used by Rhodes et al., (2004) that break down the market-to-book into two

components, mispricing component and growth opportunities components. The

concept was applied in the case of the stock merger that are different from the

context of this research. In this study, mispricing will be measured by comparing

the predicted value of market-to-book (M/BPre) with the actual value of market-

to-book (M/BAct). The argument is that the actual market value-to-book should

have reflected the company's fundamental factors, but due to the non-fundamental

factors, it is possible that the actual value is not as it should be. Therefore, the

expected difference between the predicted value and actual market to book can be

used as an indicator of mispricing. Model prediction of market-to-book value is

formed based on fundamental factors. Fundamental factors that will be used are

Earning Per Share (EPS), Price Earning Ratio (PER), Return on Equity (ROE),

Return on Assets ( ROA), Dividend Payout Ratio (DPR), Price to Sales (PTS),

Price to Free Cash Flow (PTFCF).

M/BPre

EPS = Earning Per Share (Net income/shares outstanding)

PER = Price Earning Ratio (Market stock price/EPS)

ROE = Return on Equity (Net income/equity)

ROA = Return on Asset (Net income/total asset)

shareofvalueBook

shareofvalueMarket=

DPR = Dividend Payout Ratio (1-Plowback ratio)

PS = Price to Sales (Market stock price/(sales/shares))

PFCF = Price to Free Cashflow (Market stock price/(Free Cash Flow/shares outstanding))

While the actual value of market-to-book will be calculated by

following formula:

M/BAct

Thus, mispricing will be measured by the formula:

Mispricing (MIS) = (M/BAkt) - (M/BPre)

2. Financial Constraints

Sample classification based on financial constraints refers to the study by Kaaro

(2004), Kaplan and Zingales (1997) and Cleary (1999). The steps are as follows:

a. Grouping initial sample based on the payment of dividends. Firms that pay

dividends included in the category of low financial constraints (LFC), while

firms that do not pay a dividend included in the category of high financial

constraints (HFC). LFC group will be given the score 1 and score 0 for HFC.

b. Establishing logit model to predict financial constraints based on financial

variables.

tii

ii RESLACKCPPROFITCR

P

PLnFC ,5432101

εβββββα ++++++=

−=

tiFCZ ,10 βα +=

Z

Z

Zie

e

eP

+=

+= − 11

1

1−

=t

tt setsNetFixedAs

CashFlowInvestmentINV

FC = Financial Constraint

CR (Current Ratio) = Current Asset/Current Liability

PROFIT = Operation Profit/Total Asset

CP (Change of Profit) = Positive change: 1, Negative change : 0

SLACK = [Cash+ Short Term Investment + Inventory + Receivables – Short Term Debt]/Asset

RE (Retained Earnings) = Retained Earnings/Aset

Pi = Probability

e = Exponential Value

c. When the probability Pi is greater than the probability cut-off (P> Pc) the firm

into the category of LFC (1), if Pi <Pc, the firm into category of HFC (0).

Determination of cut-off value is based on observation of actual dividend

policy.

3. Investment

Investment expenditure (INV) firms will be calculated by using the

following formula (Kaaro, 2004):

Investment cash flow is used to measure the net capital expenditure. The

value of net fixed assets used in the net asset value at the beginning of the period

while the value of the investment will be using the value at end of period (Vogt,

1994; Kaplan and Zingales, 1997; Cleary, 1999).

4. Capital Structure

Firm's capital structure proxy by using the ratio of debt to equity (D / E)

which will be calculated using the formula:

1,51,4,3,21,10, −−− +++++= ∑ titititititi CashLevYearCashflowMISInvestment βββββα

tit

titititi YearCashflowMISInvestment ,,3,21,10, εβββα ++++= ∑−

titiSales ,,6 εβ ++

1,65,4,3,21,10, * −− ++++++= ∑ tit

tiTITItiti LevYearCashflowKPMISKPMISInvestment ββββββα

tit

tiTITItiti YearCashflowKPMISKPMISInvestment ,5,4,3,21,10, * εβββββα ++++++= ∑−

titi SalesCash ,81,7 εββ +++ −

EquityTotal

DebtTotalRatioED =/

5. Control Variables

Besides the main variables, this research employ some control variables

that are Leverage, Cash Flow, Cash, Sales, Year (age of the firms), Tangible to

Asset Ratio (TAR) and Size (In total asset).

Then, the model to test the hypotheses are:

Equation to test the hypotesis 1



tititititit SizeTARBMMISED ,,,,,10 // εβα +++++=

D. RESULT

1. Prediction Model of Market to Book Value

Results of regression of prediction model shows the value of coefficient of

determination is quite high which reached 62.8% (see table 1), but there is one

variables that is not significant (DPR), then excluded from the prediction model.

Table 1. Regression of Prediction Model of Market to Book Value

Note :

*** : Significant p = 0,01

** : Significant p = 0,05

*: Significant p = 0,1

Based on the regression results, the model prediction of market to book value is as

follows:

M/Bpre = 0,206 + 0,005PER + 0,005ROE + 0,010ROA + 0,133PTS + 0,110PTFCF

Then, reduction of the actual value to the prediction model find that 311

observations (62.8%) are overvalued stock and 184 observations (37.2%) are

undervalued.

Variabels Coefficient t value Constant Adjusted

R square

EPS 0,000 1,503

0.206 0.628

PER 0,005 2,147**

ROE 0,005 3,798***

ROA 0,010 2,941***

DPR 0,122 0,597

PTS 0,133 2,350**

PTFCF 0,110 21,665***

2. Test of hypothesis 1

Table 2. Test of the effect of mispricing on investment

Note :




The results of first hypothesis testing show that mispricing occurred in the

firm’s stock price has positive influence on the level of investment. The results in

accordance with previous studies (eg Chang et al, 2005; Chang et al, 2007; Xiao,

2000; Baker et al, 2003; Alzahrani, 2006; Polk and Sapienza, 2004). This result

indicates that the value of the stock market in Indonesia provide information for

managers relating to the firm’s investment decisions. This result are also

consistent and can be explained by two theories, market timing and catering

hypothesis. High stock price can be considered by managers as a sign that

investors have a positive perception to the firm's investment decision. This result

also may indicate that overpriced stocks tend to increase the firm's investment

opportunities. Robustness test on the second model show consistent mispricing

Model Dependent Variables

Independent Variables Coeficient t value

Main Model Investment

(INV)

Constant 0,210 6,634***

Mispricing 0,021 3,095***

Cashflow 0,132 2,254**

Year 0,003 3,166***

Robustness test Investment

(INV)

Constant 0,544 10,777***

Mispricing 0,010 1,758*

Cashflow 0,348 6,285***

Year 0,002 2,253**

Leverage -0.406 -10,929***

Cash 0,450 2,708***

Sales -0.304 -4,426***

RESLACKPROFITP

PLnFC

i

ii 526,1084,1666,3426,1

1+++−=

−=

affects investment levels but the significance level is decreased. These three

variables, Leverage, Cash and Sales show significant effect on investment and

consistent with the results of previous research.

3. Test of Hypothesis 2

Table 1. Logit Regression to Predict Financial Constraint

Note :




Based on logit regression model there are two variables that are not

significant (CR and CP), then excluded from the prediction model. The predicted

model of financial constraint are:

To ensure that the model has the ability to predict the precise, this research use

classification cross between actual and predicted observation indicates that the

prediction model has predictive ability of 73.3 percent.

Variabels Coefficient Wald

statistik

Nagelkerke’

R square

Constant - 1,426 40,436***

0.234

CR -0,064 1,564

PROFIT 3,666 11,562***

CP - 0,133 0,416

RE 1,526 24,389***

SLACK 1,084 3,834**

Table 5. Test of the effect of mispricing on investment based on the level financial constraint

Note :




The second hypothesis indicates that the degree of financial constraint do

not affect the level of the effect of mispricing on investment. These findings

contrast with the theory and previous research results (Stein, 1996; Baker et al,

2003; Shleifer and Vishny, 2003; Chang et al, 2005; Chang et al, 2007). No

difference based on financial constraint shows that whatever the level of their



Main Model Investment

(INV)

Constant 0,119 4,421***


Cashflow 0,143 1,759*

Year 0,001 1,120

FC 0,257 9,272***

FC*MIS -0.029 -1,902*

Robustness test Investment

(INV)

Constant 0,494 10,178***


Cashflow 0,124 1,696*

Year 0,001 1,335

Leverage -0.328 -8,174***

Cash 0,164 1,242

Sales -0.327 -5,868***

FC 0,125 4,535***

FC*MIS -0.022 -1,630

financial constraints, the two groups of firms will react equally to the changes in

market prices. The uniformity of response in both LFC and HFC can be explained

by the theory of Catering hypothesis which states that one reason why managers

respond to the stock market because the stock can affect the "reputation" and their

compensation.

Table 3. Test of the effect of mispricing on capital structure

Note :




The results of third hypothesis test show consistency with the theory (Tobin,

1969; Furstenberg, 1977; Chirinko and Schaller, 2007) and previous research

(Hovakimian et, al 2001). According to Hovakimian et al (2001), in addition to

the reasons for investment financing, the condition can also be used by overvalued

firms to achieve the desired leverage in a way pay off some debts with the

proceeds from the sale of shares. Conversely, if stocks have undervalued, it will

make managers refrain from selling stock due to the relative cost of capital



Without Dummy D/E

Constant -4,306 -3,950***

M/B 0,057 2,478**

Size 0,270 4,948***

TAR 0,118 0,301

MISPRICING -0,066 -2,512**

With Dummy

(FC ; LFC :1, HFC : 0)

D/E

Constant -4,622 -4,267***

M/B 0,057 2,499**

Size 0,319 5,683***

TAR -0,498 -1,149

MISPRICING -0,066 -2,529**

FC -0,578 -3,197***

becomes greater. This study also show that firms that have market value to book

high leverage tends to be followed by a low level.

E. CONCLUSION AND LIMITATION

1. Conclusion

By using proxy measures that are different from previous mispricing

studies, this study finds that (1) The changes in the market value of firm stock

have a positive impact on the level of corporate investment. The condition of high

stock price will increase the firm's investment opportunities, then increase the

likelihood of a company to increase its investment. Conversely, the low stock

price will tend to reduce investment company. But (2), this effect is not influenced

by differences in the financial constraint. Every manager of the company will

react equally to changes in market prices of their stocks. In addition, (3) the

mispricing is also having a negative impact on the firm's capital structure,

although with a relatively small portion.

2. Limitation

The first limitation of this study is that the number of samples used only 99

firms from 350 listed firms in Indonesia Stock Exchange. Second, the

classification of financial constraints based on dividend policy can still be debated

because there is argument that firms do not pay dividends more appropriately

reflect the financial distress rather than financial constraints. The third limitation

is the regression model based on panel data estimation have not considered the

selection of appropriate panel data.

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