DOES MISPRICING AFFECT INVESTMENT AND CAPITAL STRUCTURE OF INDONESIAN FIRMS?

Risal Rinofaha, Irwan Trinugrohob1

Alumni of Master of Science in Management, Gadjah Mada University Jl. Nusantara, Kampus Bulaksumur, Yogyakarta, Indonesia 55281

Faculty of Economics, Sebelas Maret University

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

Corresponding author +62274868298, +62271668765

Email addresses: irwan_feuns@yahoo.co.id, irwan@fe.uns.ac.id

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 firms 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 firms 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.

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 marketto-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 = 0 + 1 EPSt 1 + 2 PERt 1 + 3 ROEt 1 + 4 ROAt 1 + 5 DPRt 1 + 6 PS t 1 + 7 PFCFt 1 + EPS PER ROE ROA = Earning Per Share (Net income/shares outstanding) = Price Earning Ratio (Market stock price/EPS) = Return on Equity (Net income/equity) = Return on Asset (Net income/total asset)

DPR PS PFCF

= Dividend Payout Ratio (1-Plowback ratio) = Price to Sales (Market stock price/(sales/shares)) = 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 =
Market value of share Book value of share

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.
P FCi = Ln i 1 P i = 0 + 1CR + 2 PROFIT + 3 CP + 4 SLACK + 5 RE + i ,t

Z = 0 + 1 FC i ,t
1 eZ Pi = = 1 + e Z 1 + e Z

FC CR (Current Ratio) PROFIT

= Financial Constraint = Current Asset/Current Liability = Operation Profit/Total Asset

CP (Change of Profit) = Positive change: 1, Negative change : 0 SLACK = [Cash+ Short Term Investment + Receivables Short Term Debt]/Asset Inventory +

RE (Retained Earnings) = Retained Earnings/Aset Pi e = Probability = 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):
INV t = Investment CashFlow NetFixedAs sets t 1
t

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:

D / E Ratio =

Total Debt Total Equity

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

Investment i ,t = 0 + 1 MIS i ,t 1 + 2 Cashflow i ,t + 3 Yeari ,t + i ,t

t

Investment i ,t = 0 + 1 MIS i ,t 1 + 2 Cashflow i ,t + 3 Yeari ,t + 4 Lev i ,t 1 + 5 Cashi ,t 1

+ 6 Salesi ,t + i ,t

Equation to test the hypotesis 2

Investment i ,t = 0 + 1 MIS i ,t 1 + 2 KPI ,T + 3 MIS * KPI ,T + 4 Cashflowi ,t + 5 Year + i ,t

t

Investmenti ,t = 0 + 1 MISi ,t 1 + 2 KPI ,T + 3 MIS * KPI ,T + 4 Cashflowi ,t + 5 Year + 6 Levi ,t 1

+ 7 Cash i ,t 1 + 8 Sales + i ,t
Equation to test the hypotesis 3

D / E t = 0 + 1 MIS i ,t + M / B i ,t + TAR i ,t + Size i ,t + i ,t

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 Adjusted Variabels EPS PER ROE ROA DPR PTS PTFCF Note : *** : Significant p = 0,01 ** : Significant p = 0,05 *: Significant p = 0,1 Coefficient 0,000 0,005 0,005 0,010 0,122 0,133 0,110 t value 1,503 2,147** 3,798*** 2,941*** 0,597 2,350** 21,665*** 0.206 0.628 Constant R square

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.

2.

Test of hypothesis 1

Table 2. Test of the effect of mispricing on investment

Model Dependent Variables Independent Variables Constant Main Model Investment (INV) Mispricing Cashflow Year Constant Mispricing Cashflow Robustness test Investment (INV) Year Leverage Cash Sales Coeficient 0,210 0,021 0,132 0,003 0,544 0,010 0,348 0,002 -0.406 0,450 -0.304 t value 6,634*** 3,095*** 2,254** 3,166*** 10,777*** 1,758* 6,285*** 2,253** -10,929*** 2,708*** -4,426***

Note : *** : Significant p = 0,01 ** : Significant p = 0,05 *: Significant p = 0,1 The results of first hypothesis testing show that mispricing occurred in the firms 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 firms 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

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

Variabels Constant CR PROFIT CP RE SLACK Note : *** : Significant p = 0,01 ** : Significant p = 0,05 *: Significant p = 0,1

Coefficient - 1,426 -0,064 3,666 - 0,133 1,526 1,084

Wald statistik 40,436*** 1,564 11,562***

Nagelkerke R square

0.234 0,416 24,389*** 3,834**

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:

P FC i = Ln i = 1,426 + 3,666 PROFIT + 1,084 SLACK + 1,526 RE 1 P i 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.

Table 5. Test of the effect of mispricing on investment based on the level financial constraint
Dependent Variables Independent Variables Constant Mispricing Main Model Investment (INV) Cashflow Year FC FC*MIS Constant Mispricing Cashflow Year Robustness test Investment (INV) Leverage Cash Sales FC FC*MIS

Model

Coeficient 0,119 0,036 0,143 0,001 0,257 -0.029 0,494 0,031 0,124 0,001 -0.328 0,164 -0.327 0,125 -0.022

t value 4,421*** 3,462*** 1,759* 1,120 9,272*** -1,902* 10,178*** 3,355*** 1,696* 1,335 -8,174*** 1,242 -5,868*** 4,535*** -1,630

Note : *** : Significant p = 0,01 ** : Significant p = 0,05 *: Significant p = 0,1 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

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
Model Dependent Variables Independent Variables Constant M/B Without Dummy D/E Size TAR MISPRICING Constant M/B With Dummy (FC ; LFC :1, HFC : 0) D/E TAR MISPRICING FC -0,498 -0,066 -0,578 -1,149 -2,529** -3,197*** Size Coeficient -4,306 0,057 0,270 0,118 -0,066 -4,622 0,057 0,319 t value -3,950*** 2,478** 4,948*** 0,301 -2,512** -4,267*** 2,499** 5,683***

Note : *** : Significant p = 0,01 ** : Significant p = 0,05 *: Significant p = 0,1

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

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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