Financial Leverage And ITS Effect On Return On Equity (ROE) And Earnings Per Share (EPS) : An Empirical Of Mining Industry Listed In Indonesia Stock Exchange
FINANCIAL LEVERAGE AND ITS EFFECT ON
RETURN ON EQUITY (ROE) AND EARNINGS PER SHARE (EPS)
(An Empirical Analysis of Mining Industry Listed in Indonesia Stock Exchange)
By
Andal Pradipta
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INTERNATIONAL PROGRAM
MANAGEMENT MAJOR
FACULTY OF ECONOMICS AND SOCIAL SCIENCES
STATE ISLAMIC UNIVERSITY SYARIF HIDAYATULLAH
JAKARTA
1430 H/2009 M
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FINANCIAL LEVERAGE AND ITS EFFECT ON
RETURN ON EQUITY (ROE) AND EARNINGS PER SHARE (EPS)
(An Empirical Analysis of Mining Industry Listed in Indonesia Stock Exchange)
Thesis
Submitted to Faculty of Economics and Social Sciences
To Meet the Requirements in Achieving Degree of Bachelor of Economics
By
f\ndal Pradipta
604081000002
Under Supervision of
Academic Supervisor I
Academic Supervisor II
Pro[ Dr. Ahmad Rodoni, MM
Dr. Rofikoh Rokhim
NIP. 150 3 I 7 955
ｲｷＢﾰＯＧｾｭｩ＠
ｾ＿Ｍｊ＠
/
-·------
Prof. Dr. Azzam Jasin, MBA
MANAGEMENT MAJOR
FACULTY OF ECONOMICS AND SOCIAL SCJENCES
We have administered comprehensive examination to i\ndal Pradipta student
If)
604081000002
on
Wednesday.
6
August
2008
with
the
title
"FlNANCIAL LEVERAGE AND ITS EFFECT ON RETURN ON
EQUITY AND li:ARNINGS PER SHARE (AN
OF
MINING
INDUSTRY
LISTED
IN
ｾｍｐｉｒｃａｌ＠
ANALYS1S
ll'ilOONESIA
STOCK
EXCHANGE)". After proper examination of the student. we decided that this
thesis is accepted as partial requirements for the title of Bachelor of
Economics on the field of Management, State Islamic University Syarif
H idayatul lah Jakarta.
Ciputat, 6 August 2008
Comprehensive Examination Team
Prof. Dr. Abdul Hamid, MS
Deputy Dean
Prof. Dr. Ahmad Rodoni, MM
Head of Management Department
CONTENTS
Page
Biography
Abstract
Abstrak
Preface
CHAPTER I.
INTRODUCTION
A. Background
B. Problem Identification
11
C. Purpose and Significance
12
CHAPTER II. LITERATURE REVIEW
A. Company Sources of Fund
14
B. Financial Leverage
16
c.
19
Liquidity
D. Return on Equity
22
E. Earnings per Share
25
F. Previous Research
27
G. Theoretical Framework
28
H. Consideration Framework
29
CHAPTER III. RESEARCH METHODOLOGY
A. Research Scope
30
B. Sampling Method
31
C. Data Collection Method
32
D. Analysis Method
33
E. Research Variable Operational
40
CHAPTER IV. FINDINGS AND ANALYSIS
CHAPTER V.
REFERENCES
APPENDIX
A. General View on Research Object
44
B. Findings and Analysis
60
CONCLUSION
A. Conclusion
76
B. Implication
77
79
List of Tables
Page
Table 1.1
Company's Debt and Debt to Equity Ratio
Table 2.2
List of Previous Research
27
Table 3.3
Research's Variables and Its Indicators
40
7
List of Figures
Page
Figure 1.1
ROE Change Sensitivity upon EBIT Change
8
Figure 1.2
Directional Factor of Return on Equity Line
9
Figure 2.3
Corporation's Capital Scheme Philosophical Framework
28
Figure 2.4
Return on Equity
29
Figure 2.5
Earnings per Share
29
Figure 4.6
Elnusa
44
Figure 4.7
Aneka Tambang
46
Figure 4.8
Petrosea
47
Figure 4.9
International Nickel Indonesia
49
Figure 4.10
Radiant Utama Interinsco
50
Figure 4.11
Ti mah
53
Figure 4.12
Central Korporindo Internasional
56
Figure 4.13
Apexindo Pratama Duta
57
BIOGRAPHY
I. PERSONAL IDENTITY
1. Name
: Anda! Pradipta
2. Place and date of birth
: Jakarta, February 17, 1987
3. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
4. Phone
: 0818998628
5. Email
: pvogue@gmail.com
II. EDUCATION
I. Elementary school
: SD Baiturrahmah Padang
2. Junior high school
: SMPN 2 Padang
3. Senior high school
: SMA Pribadi Depok
III. ORGANIZATIONAL EXPERIENCE
1. Jakarta Debating Competition committee
2. Organizing committee on MoU between Intel and UIN
IV. FAMILY BACKGROUND
1. Father
: Riya:ntoko
2. Place and date of birth
: Sragen, August 2, 1955
3. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
4. Phone
: 08121033941
5. Mother
: S. Neni Budi Ratni
6. Place and date of birth
: Yogyakarta, Febrnary 17, 1960
7. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
8. Phone
: 08561108902
ABSTRACT
This study is an empirical work that investigates the effect of a firm's leverage
on returns and earnings. Writer undertakes the tests based on the explicit valuation
model of some researcher and tested in the mining industry in Indonesia. This is
consistent with the findings of Modigliani and Miller (1958). Results are robust to
other factors.
Using several measures for debt capacity, writer finds that the negative effect
is stronger for firms with limited debt capacity. Moreover, firms with an increase in
leverage ratio tend to have less futme investment, controlling for the potential
negative effect of growth option on leverage ratio.
These findings are consistent with a dynamic view of the pecking-order theory
that an increase in leverage reduces finns' safe debt capacity and may lead to future
underinvestment. Writer finds that the observed patterns are stronger for changes in
the long-term debt than that in the short-term debt and remain significant among
financially healthy firms.
of
Further, while leverage seems to be working well for few ｃｦｾｴ･ｧｯｲｩｳ＠
companies, it is affecting some others negatively. Companies that are moderately
geared i.e. in the range of gearing ratio of 50 percent to 85 percent have been able to
generate a good ROE. In a nutshell, it is the management who take the lead and
responsible for the usage of company's external somce of fund to leverage their
company as to maximize the practice.
Keywords: financial leverage, liquidity, return on equity, earnings per share, mining
industry, Indonesia
ABSTRAK
Penelitian ini adalah studi empiris yang menyelidiki efek dari hutang
perusaharu1 terhadap pengembalian modal dan pendapatan. Penulis menjalankan tes
berdasarkan model penghitungan dari beberapa peneliti yang selanjutnya di tes pada
industri pertambangan di Indonesia. Ini konsisten dengan penemuan dari Modigliru1i
dan Miller (1958). Hasilnya adalah bagus terhadap faktor-faktor lain.
Menggunakan beberapa pengukuran untuk hutang, penulis menemukan bahwa
perusahaan dengan kapasitas hutang yang terbatas mempunyai efek negatif yang
lebih kuat. Selebihnya, perusahaan dengan peningkatan dalam rasio hutang cenderung
untuk memiliki investasi masa depan yang lebih kecil, mengendalikan pertumbuhru1
yang potensial terhadap efek negatif pada rasio huta11g.
Penemuan ini konsisten denga11 pru1da11gan dinamis dari teori pecking-order
yang menyatakan bahwa peningkata11 hutang menurunkan kapasitas aman huta11g dari
perusahaa11 itu dru1 dapat berujtmg pada investasi yru1g kecil pada masa depan.
Penulis menemukan bahwa pola yang diteliti lebih kuat untuk perubahan pada huta11g
jangka pru1jang daripada lrntang jangka pendek dan tetap signifikan diantru·a
perusahaan denga11 finansial yang sehat.
Lebih jauh lagi, ketika hutang bekerja dengan baik untuk beberapa
perusahaan, temyata hutru1g memberika11 efek negatif pada perusahaa11 lain.
Perusahaan denga11 rasio hutang yang moderat yang berada dalrun rasio a11tara 50%
dan 85% bisa menghasilkan pengembalian modal yffi1g baik. Selanjutnya, adalah
ma11ajemen perusahaan yang memimpin dan bertanggung jawab terhadap
penggunaan dana ekstemal untuk operasional perusahaa11 dan memaksimalkarmya.
Kata kunci: hutang, likuiditas, pengembalia11 modal, laba bersih per sahrun, industri
pertrunbangan, Indonesia
PREFACE
In the name of Allah SWT, writer would like to say thank you for the
completion of this paper with the title "Financial Leverage and its Effect on Return
on Equity and Earnings per Share". This paper is a framework that aims to shed some
light on the financial structure of mining industry and further analyzes the impact of
leverage on it. The writer would like to say thank you to the following that have
given their support in making this paper possible:
1. My beloved parents for their great support and endless courage to help
me finishing this paper.
2. Dean Faculty of Economics and Social Sciences Drs. Faisal Badroen,
MBA.
3. Academic supervisor I Prof. Dr. Ahmad Rodoni, MM and academic
supervisor II Dr. Rofikoh Rokhim for their extremely helpful
assistance along with the consent to finish this paper.
4. Bisnis Indonesia for providing data to meet my data requirement for
my thesis.
5. All my friends in International Program as we have shared good times
together: Mamat, Abdul, Donal, Hendry, Iqbal, Savirul, Faqih, Fitry,
Tia, Erika, Aysa, Khairiyah, Kiki, Nada and everyone in the class that
could not be mentioned one by one.
6. All the staff in International Program office for handling the required
document especially Mrs. Fitri, and Mr. Syamsudin.
7. My tennis mates Bono, Sofyan, Rama; you guys rock.
8. Asus WSF for limitless contribution; my dependent partner; hail on
you.
9. My handy 2 gigabyte HP thumb drive for maximum mobile data
transfer.
l 0. Bignet for internet connection
111
KP9 to let me connect to virtual
world along with surfing for international journals.
11. Canadian corner in main library for providing cozy place to write this
paper.
12. The legendarily powerful yet efficient l ZZ-FE for making me
conveniently move from one place to another.
13. 'Attack' package to power up my energy to run the day; 3 packages at
a time is considered normal.
14. And to everyone that helped me to go through this paper.
CHAPTER I
INTRODUCTION
A. Background
Facing an open competition in the globalization age is one of the
toughest tasks for either state own enterprise or private company.
Corporations are highly obliged to offer excellent products or services
throughout the competition. Consumer will have more variety of choices to
products or services available in the market. Subsequently, it is just the matter
of time to survive in the competition; consumer will judge which product is
the best. Along with increasing market share, all firms aim to expand their
operation.
Competing in a tight competition needs accurate calculation where
every pace is vital and as important as corporation's current undertaking in
addition to future achievement. Most of the time, capital support is playing
important role to expand or survive in such rivalry (Padron, 2005:61). As
such, there are various ways for a corporation to get financing for their
operation, either internally or externally. At times, internally generated funds
will not be sufficient to finance all of the firm's proposed expenditures. In
these situations, the corporation may find it necessary to attract large amount
of financial capital externally or otherwise forgo the projects that are forecast
to be profitable (Ross, 2006:389).
At the same time, corporation is trying its best to create value added,
which is at the end will attract investors to put and invest their money in it.
From many indicators for investor, some of them are return on equity (ROE)
and earnings per share (EPS) of that particular corporation (Sunarto, 2001).
Investors are looking for the best performance stock, which is represented by
constantly increasing price or at least maintain its price at the particular range.
That point, later, indicates the profitability, as well as its return and earnings.
By doing so, they will be able to draw large amount of capital to develop their
size in terms of market share.
Information needed by investors in capital market is not only
fundamentally precise, but also technically defined (Sunarto, 2001 ).
Fundamental inf01mation is internally derived while technical information is
acquired externally, such as economy, politic, finance, and other factors.
Information obtained internally is usually taking form in financial report.
Fundamental and technical information can be used as a basis for investor to
predict return, risk, amount, time, and other factors related to activity in
cap ital market.
One of the most imp01tant concepts in all of finance deals with risk
and return. As it goes with one of the financial management principles, it says
that the risk return trade off-we will not take additional risk unless we expect
to be compensated with additional return (Keown, 2005:26). Risk is the
prospect of an unfavorable outcome. This concept has been measured
operationally as the standard deviation or beta (Keown, 2005:190). The
practice of corporate risk management has changed dramatically over the past
two decades. Originally, risk management was implemented on an
uncoordinated basis across different units of the firm. The primary focus of
these ad hoe risk management programs was to minimize costs. Today,
however, risk management of currency exposure has, in many cases, evolved
into a firmwide exercise that addresses both short-te1m and long-term
exposures and encompasses financial as well as operational hedges.
The ultimate goal of firmwide risk management is to reduce risk while
placing the firm in a position to benefit from opportunities that arise from
exchange rate changes. For example, Davis and Militello (1995) describe how
Union Carbide employs a firmwide perspective in risk management. The
company uses a one-year horizon for financial hedges (e.g., foreign-exchange
derivatives), whereas for longer horizons, operational adjustments are made in
sourcing, utilization of different plant locations, and pricing.
Firmwide risk management for multinational corporations (MNCs) is
the combination of both financial and operational hedges as part of an
integrated risk management strategy aiming at reducing exposure to foreignexchange risk (Cartera, 2001). Changes in exchange rates can influence
MNCs' current and future expected cash flows and ultimately, stock prices.
The direction and the magnitude of changes in the exchange rate on firm value
are a function of the firm's corporate hedging policy and the structure of its
foreign currency cash flows. The latter depends on the firm's competitive
position in the industries in which it operates. The fo1mer indicates whether
the MNC utilizes operational hedges and financial hedges to manage currency
exposure.
Leverage is traditionally viewed as arising from financing activities:
finns boITow to raise cash for operations. The standard measure of leverage is
total liabilities to equity. However, while some liabilities-like bank loans and
bonds issued are due to financing, other liabilities--like trade payables,
deferred revenues, and pension liabilities-result from transactions with
customers and suppliers in conducting operations. Financing liabilities are
typically traded in well-functioning capital markets where issuers are price
takers.
Compared to many areas of corporate finance, relatively little is known
about the fundamental detenninants of the expected rates of return of
individual firms-that is, how the characteristics of a paiticular firm affect
'
expected returns earned by security-holders.
Miller-Modigliani (1958; henceforth MM) argued rigorously that the
value of a firm is independent of its capital structure. The immediate
implication of Proposition I was that the return on equity capital is an
increasing function of leverage. This is because debt increases the riskiness of
the stock and hence equity shareholders will demand a higher return on their
stocks.
MM's Proposition II stated that the rate of return on common stock of
companies whose capital structure includes some debt is equal to the
appropriate capitalization rate for a pure equity stream plus a premium related
to financial risk (Sivaprasad, 2007). The impact of these propositions on
corporate finance is immense but the original sample they used is very limited.
Further empirical work uses much larger samples but results are mixed. Some
authors (Hamada, 1972; Bhandari, 1988) show that returns increase in
leverage, others show that they decrease in leverage (Dimitrov and Jain, 2005;
Penman 2007).
Financial leverage, in turn, results from a company resorting to debts.
Their role in the structure ensures a greater return on equity in the case of
prosperity, but in the case of a slump brings about greater losses, as it
increases liabilities. Each of these decisions has advantages and involves risk
at the same time. Analysis of leverage aims at providing infonnation al;>out the
advantages and risk resulting from it. By putting emphasize into financial
leverage, it is a step closer to reduce risk as well as predicting the return.
In the theory of firm's capital structure and financing decisions, the
Pecking Order Theory or Pecking Order Model was developed by Stewart C.
Myers and Nicolas Majluf in 1984. It states that companies prioritize their
sources of financing (from internal financing to equity) according to the law of
least effort, or of least resistance, preferring to raise equity as a financing
means of last resort. Hence, internal funds are used first, and when that is
depleted, debt is issued, and when it is not sensible to issue any more debt,
equity is issued. This theory maintains that businesses adhere to hierarchy of
financing sources and prefer internal financing when available, and debt is
preferred over equity if external financing is required.
Mining industry has been the main source of income for Indonesia for
a long time. Given the abundant resources, Indonesia is one of the most
attractive places for foreign investors. According to PricewaterhouseCoopers'
research, the contribution of mining industry to the economy of Indonesia in
2003 reached around Rp. 19.5 trillion, which is mostly in the form of
government income (Rp. 9.3 trillion) and purchases from local suppliers (Rp.
7.1 trillion).
Expenditure for the public interest is quite large such as for regional
I
and social development, reached around Rp. 604 billion (2003), staff training
(Rp 164 billion), research and development (US$ 1.04 million). Meanwhile,
expenditures for the reclamation, mine closure and environmental control
reached US$ 83.6 million.
The numbers of Indonesian workers absorbed by the mining industry
in 2003 came out at 33,112 people. These numbers are resulted from research
involving 33 companies that have been operating and 35 exploration
companies during 1999-2003 and do not reflect all gold and coal producers in
Indonesia. Some of them are already go public while some others have yet to
neither list their shares in stock market nor offer their shares to public. If all
the data is entered for various types of minerals industry, the numbers will
cettainly increase and affect the entire figures.
Below is the list of go public mining company in Indonesia (figures in
Rupiah expressed in thousands, data of2007):
Table I.I
Comoanv's Debt and Debt to Equitv Ratio
Company
No
Short term debt
Long term debt
DER
18,995,251,422
1,350,972,348
0.11
Bumi Resources
7,984,974,395,526
5,338,504,954,160
1.26
3
Indo Tambangraya Megah
2,245,990,428,000
755,213,882,000
0.68
4
Resource Alam Indonesia
60,762,715,000
29, 708,899,000
1.09
5
Perdana Karya Perkasa
76,675,215,684
76,785,475,234
0.88
6
Tambang Batubara Bukit
Asam
695,010,000,000
421,789,000,000
0.40
496,740,688,000
182,048,658,000
0.95
Petrosea
463,854,200,814
1,933,740,064,186
1.09
Apexindo Pratama Dula
918,095,000,000
277,169,000,000
1.26
Elnusa
3,688,450,000,000
2,337,494,000,000
1.80
Energi Mega Persada
3,548,668,475,674
10,505,938,001,544
2.85
121,440,162,625
111,038,745,798
l.29
1,798,816,747,000
1,474,300, 753,000
0.37
1
A TPK Resources
2
7
8
9
10
11
12
13
14
15
16
17
18
19
Medco Energi Internasional
Radiant Utama Interinsco
Aneka Tambang
I 94,792,000,000
114,063,000,000
1.69
Cita Mineral Investindo
2,366,059,276,000
2,339,218,588,000
0.36
International Nickel Indonesia
1,350,230,000,000
323,163,000,000
0.50
Timah
50,837,822,000
54,437,767,000
0.16
Central Korporindo Int' I
117, 166,000,000
21,315,000,000
3.29
Citatah Industri
102,024,224,000
2,680,594,000
5.33
Mitra Jnvestindo
Source: Bi.mis Indonesia
An alternative measure of overall company performance is return on
equity (ROE). A company's ROE is affected by the same income statement
items that affect ROA as well as by the company's degree of financial
leverage, which is shown as follows (Ross, 2006:467):
ROE
ROA x Leverage measure
Net income
Net income
Equity capital
Total assets
x
Total assets
Equity capital
Figure 1.1
ROE change sensitivity upon EBIT change
(Source: Tadeusz Dudycz, "The Different Faces of Leverage")
Figure 1.2 shows two variants of financing the same investment.
Variant B involves a greater contribution of debts in the capital structure, and
variant A smaller. The total capital is identical in both variants. We can see
that variant B, with respect to the size of EBIT, initially ensures a smaller
return on equity, which grows after crossing a certain value of EBIT. Variant
B also leads to a higher sensitivity of changes in return on equity to changes in
EBIT. The sensitivity depends on changes in the
J3 angle.
If we assume that, just as in the case of operating leverage, the
sensitivity of changes in return on equity (ROE) to EBIT change is a measure
of financial leverage in the static approach (independent ofEBIT value), then
on the basis of Figure 1.3 we can derive that the financial leverage FL equals:
!!.ROE
FL=wfJ· = - -·
f!.EBIT
}{_()
/
.dROE
Figure 1.2
Directional factor (slope) ofretum on equity line
(Source: Tadeusz Dudyez, "The Different Faces of Leverage")
The leverage measure is simply the inverse of the capital ratio (when
only equity counts as capital). The higher the capital ratio, the lower the
leverage measure and degree of financial leverage.
It is also important to look for a financial capital to extend the
capacity. Thus, due to the increasing of credit by commercial banks, it is
natural that financial leverage plays important role on the development of a
firm. While exercising financial leverage, the cost of that leverage is also
increasing. This is also affecting net income, ROE, and BPS of that particular
firm.
This paper contributes to the existing literature on the relationship of
returns and capital structure in three directions. First, this is a study which
expands the limited work carried out on leverage and returns by examining
leverage as an independent variable and its impact on returns. Second, the
paper tests for linearity of leverage and return. This is an important testI to
enable the better understanding of the traditionalist theory of capital structure
and optimal capital structure. Thirdly, the writer undertakes robustness checks
with several factors.
The definitions of financial leverage used in corporate finance
textbooks vary, but most textbooks discuss this result, and the explanation
offered for a positive relationship between financial leverage and the expected
rate of return is usually along the same lines. All else equal, a firm with high
financial leverage has high external financial capital and low internal capital,
so that the additional revenue from one additional unit of production is offset
by a relatively small increase in leverage cost.
B. Problem Identification
Attracting and convincing investors have never been easy for it ties
with company's value, performance, goodwill, as well as its reputation. It is
also important to know the relation between financial leverage and ROE along
with EPS. Therefore, corporation can consider how large in taking external
financing to can-yon their operation.
In fact, each and every year, under certain condition, there is always
corporation with the closest relation on the topic chosen for the research: the
higher the financial leverage, the higher the ROE and EPS (Pamela, 2006).
Based on the background explained previously, the writer wants to focus on
the problem needs to be addressed which is impact of leverage in terms of its
effects on ROE and EPS in mining industry. Aside from main focus of the
problem, there are also other problems:
1. Does financial leverage and liquidity affect ROE for listed mining
company in Indonesia Stock Exchange from year 2005-2007?
2. Does financial leverage and liquidity affect EPS for listed mining
company in Indonesia Stock Exchange from year 2005-2007?
C. Purpose and Significance
I. Purpose
This research seeks to analyze relation between financial leverage
and ROE as well as EPS. The aims of the paper are:
a. To examine the significance of financial leverage and liquidity towards
ROE for listed mining company in Indonesia Stock Exchange from
year 2005-2007.
b. To examine the significance of financial leverage and liquidity towards
EPS for listed mining company in Indonesia Stock Exchange from
year 2005-2007.
This paper also presents a twofold approach to the measurement of
leverage: static and dynamic, which give two separate parameters
providing the company board with different information. By this research,
expectantly it will bring benefit to those who needed it especially for
mining industry in this country.
2. Significance
Separately, there are various conditions that later influence the
significance of the research:
a. Academically,
this research expects the contribution for the
development of lmowledge and general information on effect of
leverage in mining industry, and parties related to the problem of
research.
b. Practically, this research offers initiative for corporation, particularly
mining company, related to the problem ofresearch.
c. Socially, this research provides idea that keenly brings changes in the
way people think, act, as well as providing general knowledge for
society.
d. Technically, this research tries to make a good study of both the
concept and methodology on top of the entire research activity. On the
other hand, it is also possible that this research is used as a basis
reference for next research with related topic.
CHAPTER II
LITERATURE REVIEW
A. Company Sources of Fund
Sources of fund for a company in general include the following
(Husnan, 1994):
I. Internal
a. Retained earning, influenced by:
l) Amount of earning in that particular period
2) Dividend policy
The higher the dividend, the lower the retained earnings. Vice
versa.
3) Reinvestment
b. Depreciation accumulation
2. External
a. Debt, classified as follows:
I) Short term debt(< I year)
2) Mid term debt (I-JO years)
3) Long term debt(> I 0 years)
b. Owners' equity
Equity from owners of the company for limitless time. Accordingly, it
is an equity being staked for all business risk as well as other risk.
Sources of financing from owners' equity:
I) Common stock
It represents the ownership in a company. Common stock does not
have a maturity date, but exists as long as the firm does. Nor does
common stock have an upper limit on its dividend payment. The
common shareholders have the right to the residual income after
bondholders and preferred stockholders have been paid.
2) Preferred stock
Security with characteristics of both common stock and bonds. It is
similar to common stock because it has no fixed maturity date, the
nonpayment of dividends does not bring on bankruptcy, and
dividends are not deductible for tax purposes. Preferred stock is
similar to bonds in that dividends are limited in amount.
3) Cumulative preferred stock
Basically, cumulative preferred stock is the same as preferred
stock. What makes them different is that the earlier has cumulative
right, wherein the company does not generate profit for some
period, dividend will be suspended until the company generates
profit. It requires all past unpaid preferred stock dividends to be
paid before any common stock dividends are declared.
B. Financial Leverage
The study of the combination of internal and external financial
resources in company liability has generated controversy over the years.
Especially significant is Miller and Modigliani's (Ml\i!) important contribuuion
to capital structure theory of 195 8, which showed that, given a company's
investment policy, and not taking taxes and transaction costs into account, the
choice of financial policy does not affect the current market value of the
company. However, because real markets are far from the so-called "perfect
capital markets" on which MM based their work, numerous studies have
shown the interdependence among investment decisions, financing decisions,
and fitm value. Continued interest in this topic justifies further study of a
company's financial decisions that determine its level of debt.
In MM tests of proposition II, returns to shareholders are approximated
by actual shareholder net income and estimations are made in the cross section
of all firms in a risk class for a single year. As the authors discuss amongst
themselves, this is very crude. The writer uses panel data that contains
information for three consecutive years and combines the cross section with
the time series. The writer represents returns to shareholders as stock returns
in excess of risk-free rate.
MM defined leverage as ratio of the market value of bonds and
preferred debt to the market value of all securities; the writer measures
leverage as the ratio of the book values of total debt to total capital. Leverage
based on book values is associated with lower average returns, whereas
leverage based on market is associated with higher returns (Fama and French,
1992; henceforth FF). He concluded that this variation in their findings is
explained and absorbed by the book-to-market effect. In MM, the only
independent variable is the leverage ratio to test for the linearity of the
relationship. In this study, on top of the leverage ratio, the writer uses
variables that reflect average leverage in every risk class and idiosyncratic
risk, including the FF risk factors.
Investigation has been done on the relationship between leverage and
returns (Arditti, 1967). He defined returns as the geometric mean of returns
and leverage was defined as the ratio of debt measured in book value to equity
measured at market value. He found leverage to have a negative sign in the
regressions-though insignificant-to returns. He argued that the negative
relationship is because there are inter-firms risks which are not accounted for
by the probability distribution variables. Others also examined the relationship
between leverage and returns (Hall, 1967). He defined returns as profits after
tax and ratio of equity to assets as an indicator for leverage. His results show
that equity to assets was positively related to returns, indicating that returns
have an inverse relationship with returns. This was because large amounts of
leverage (i.e. low equity to assets) imply high risks, and hence profitable firms
take some of the exceptional returns in the form of reduced risks. Another
researcher also undertook an examination of the effect of leverage on industry
returns (Baker, 1973). He measured leverage inversdy as the ratio of equity to
total assets for the leading firms in an industry over the he year period. He too
found that relatively large amounts of leverage tend to raise industry profit
rates, more leverage implying greater risks. In this study, in addition to Ithe
leverage ratio and its square, the writer uses three variables that reflect
leverage, including its ratio and the particular return and earnings.
From various financial ratios, there are some ratios and corporate
financial information that can be used to predict return. Financial ratio is
divided into five categories (Ang, 1997): (I) liquidity ratio; (2) activity ratio;
(3) profitability ratio; (4) leverage ratio; and (5) market ratio. Profitability
ratio consists of seven ratios: gross profit margin (GPM), net profit margin
(NPM), operating return on assets (OPROA), return on asset (ROA) or return
on investment (ROI), return on equity (ROE), and operating ratio (OPR).
Leverage ratio is divided into eight different ratios: debt ratio, debt to
equity ratio, long-tenn debt to equity ratio, long-term debt to capitalization
ratio, times interest earned, cash flow interest coverage, cash flow to net
income, and cash return on sales (Ang, 1997: 18). Leverage ratio shows how
large debt ratio which is ratio from total debt to total assets.
C. Liquidity
Liquidity is the speed and ease at which an asset can be converted into
cash. The more cun-ent assets that a firm has relative to its current liabilities,
the greater the firm's liquidity (Keown, 2005:41). Or else, the ability of a firm
to pay its bills on time. Measuring a firm's liquidity is not an easy task, for it
has two approaches. The first approach compares cash and the assets that
should be converted into cash within the year. The assets here are the current
assets, and the debt is the current liabilities in the balance sheet. The current
ratio measured by its current assets relative to its current liabilities.
Furthermore, remembering that the three primary current assets include cash,
accounts receivable, and inventories, it is possible to make the measure of
liquidity more restrictive by excluding inventories, the least liquid of the
current assets, in the numerator. This revised ratio is called acid-test ratio.
The second approach of liquidity examines the firm's ability to convert
accounts receivable and inventory into cash on a timely basis (Keown,
2005:75). The conversion of accounts receivable into cash may be measured
by computing how long it takes to collect the firm's receivables; that is, how
many days of sales are outstanding in the form of accounts receivable. It can
be answered by computing the average collection period, which indicates how
rapidly a firm is collecting its credit, measured by the average number of days
it takes to collect its accounts receivable. It could be the same conclusion by
measuring how many times accounts receivable are "rolled over" during a
year, or the accounts receivable turnover ratio, measured by the number of
times its accounts receivable are collected during a year.
As a general rule, management would want to collect receivables
sooner rather than later-that is, reduce collection period and increase
inventory turnover. However, it may be that a company's management would
intentionally extend longer credit terms as a policy for reasons it deems
justifiable. Alternatively, slower collection could mean that management is
simply not being as careful at enforcing its collection policies. In other words,
it may not be managing receivables effectively. Some people may want to
know the same thing for inventories that is just determined for accounts
receivable: How many times are a firm turning over inventories during the
year? In this manner, some insight can be gain into the liquidity of inventories.
The inventory turnover ratio indicates the relative liquidity of inventories, as
measured by the number of times a firm's inventories are replaced during the
year.
The impact of the liquidity of a firm's assets on optimal leverage has
been a source of debate for many years. Williamson (1988) and Shleifer and
Vishny (1992) predict that asset liquidity increases optimal leverage, while
Morellec (200 l) and Myers and Rajan (1998) argue that its effect is negative
or curvilinear. The rationale for a positive effect of asset liquidity on leverage
relies on the idea that less liquid assets sell at higher costs, which increases the
costs of liquidation, bankruptcy, and debt. Lower asset liquidity therefore
creates the need to reduce the probability of costly default by lowering the
leverage. Yet models that predict a non-positive effect argue that lower asset
liquidity makes it more costly for managers to expropriate value from
bondholders. Thus, lower asset liquidity reduces the costs of debt, and as a
result, companies use more debt. Despite substantial progress in modeling the
relation between asset liquidity and leverage, limited empirical evidence
pertains to this effect because of the difficulty of obtaining a measure of asset
liquidity. In turn, existing studies that examine the relation between asset
liquidity and leverage - such as Alderson and Betker (l 995), Kim (1998), and
Benmelech, Garmaisc, and Moskowitz (2005) - tend to limit their attention to
narrow and specific samples offinns or assets.
Merton (1987) states that relatively larger firms will have a greater
trading interest since more individuals and institutions will have positions in
the firm. Larger films will also be more carefully scrutinized by both
professional and unsophisticated analysts. The increased information
gathering makes prices more efficient, thereby reducing adverse selection
costs. By providing a larger pool of trades to offset adverse selection costs,
increases in the breadth of ownership, paiticularly smaller shareholders, can
offset additional adverse selection costs and lead to reduced spreads. We
therefore expect increases in finn size, volume, and the number of
shareholders to be negatively related to changes in spreads.
The expected impact of corporate diversification on liquidity is
unclear. There are arguments and evidence supporting both a positive and
negative relationship between diversification and liquidity. Chang and Yu
(2004) suggest diversified firms have reduced adverse selection costs since
firm-level prices are less sensitive to information asymmetries arising in
individual divisions. In addition, Benston and Hagerman (1974) point out that
since market makers hold undiversified portfolios, corporate diversification
reduces inventory holding costs by reducing volatility. The reduction in either
adverse selection costs or inventory holding costs would reduce spreads for
diversifying firms. Alternatively, Nanda and Narayanan (1999) suggest that
allowing each of a diversified firm's divisions to trade independently
facilitates price discovery by investors. More accurate market prices would
mitigate adverse selection problems and improve liquidity. Note that price
discovery arguments do not preclude offsetting diversification effects.
D. Return on Equity
There are only three ratios from profitability ratio that have
significance on the corporation's profit forecast for a year ahead (Machfoedz,
1994). Those three ratios are: GPS, NIS, and NINW. GPS is usually stated as
gross profit margin (GPM), NIS also acknowledged as net profit margin
(NPM), and net income to net w01th (NINW) as return on equity (ROE).
Furthermore, from the three ratios, the only ratio that has significant relation
(1%) with earning prediction is net income to net worth (NINW) or retnrn on
equity (ROE) (Machfoedz, 1994).
The financial structure of a corporation provides the market with
information about the firm, with the market value of the firm increasing with
the level of debt (Ross, 1977). This can be taken to mean that, if managers
raise the level of debt, then it is because their expectations for the future of the
company permit it to meet its obligations, making it clear that the risk of
insolvency is not relevant. The value of a company and the size of its debt are
positively correlated (Raviv, 1990). Variations in the company's level of debt
will affect its market value, since the firm's change in capital structure
transmits information about the future expectations of the company. For
example, an announcement of the reduction of the number of common stocks
in exchange for a debt offering has a positive effect on the market, which
becomes a negative effect when the reverse happens (Copeland and Lee,
1991).
There is a positive relationship between stock retnrns and leverrge
(Hamada, 1972; Bhandari, 1988). Both test the relationship in the cross
section of all firms. Calculation on returns as profits after taxes and interest
which is the earnings the equity and preferred shareholders receive on their
investment for the period (Hamada, 1972). The \'
RETURN ON EQUITY (ROE) AND EARNINGS PER SHARE (EPS)
(An Empirical Analysis of Mining Industry Listed in Indonesia Stock Exchange)
By
Andal Pradipta
604081000002
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· ,ffikasi
INTERNATIONAL PROGRAM
MANAGEMENT MAJOR
FACULTY OF ECONOMICS AND SOCIAL SCIENCES
STATE ISLAMIC UNIVERSITY SYARIF HIDAYATULLAH
JAKARTA
1430 H/2009 M
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FINANCIAL LEVERAGE AND ITS EFFECT ON
RETURN ON EQUITY (ROE) AND EARNINGS PER SHARE (EPS)
(An Empirical Analysis of Mining Industry Listed in Indonesia Stock Exchange)
Thesis
Submitted to Faculty of Economics and Social Sciences
To Meet the Requirements in Achieving Degree of Bachelor of Economics
By
f\ndal Pradipta
604081000002
Under Supervision of
Academic Supervisor I
Academic Supervisor II
Pro[ Dr. Ahmad Rodoni, MM
Dr. Rofikoh Rokhim
NIP. 150 3 I 7 955
ｲｷＢﾰＯＧｾｭｩ＠
ｾ＿Ｍｊ＠
/
-·------
Prof. Dr. Azzam Jasin, MBA
MANAGEMENT MAJOR
FACULTY OF ECONOMICS AND SOCIAL SCJENCES
We have administered comprehensive examination to i\ndal Pradipta student
If)
604081000002
on
Wednesday.
6
August
2008
with
the
title
"FlNANCIAL LEVERAGE AND ITS EFFECT ON RETURN ON
EQUITY AND li:ARNINGS PER SHARE (AN
OF
MINING
INDUSTRY
LISTED
IN
ｾｍｐｉｒｃａｌ＠
ANALYS1S
ll'ilOONESIA
STOCK
EXCHANGE)". After proper examination of the student. we decided that this
thesis is accepted as partial requirements for the title of Bachelor of
Economics on the field of Management, State Islamic University Syarif
H idayatul lah Jakarta.
Ciputat, 6 August 2008
Comprehensive Examination Team
Prof. Dr. Abdul Hamid, MS
Deputy Dean
Prof. Dr. Ahmad Rodoni, MM
Head of Management Department
CONTENTS
Page
Biography
Abstract
Abstrak
Preface
CHAPTER I.
INTRODUCTION
A. Background
B. Problem Identification
11
C. Purpose and Significance
12
CHAPTER II. LITERATURE REVIEW
A. Company Sources of Fund
14
B. Financial Leverage
16
c.
19
Liquidity
D. Return on Equity
22
E. Earnings per Share
25
F. Previous Research
27
G. Theoretical Framework
28
H. Consideration Framework
29
CHAPTER III. RESEARCH METHODOLOGY
A. Research Scope
30
B. Sampling Method
31
C. Data Collection Method
32
D. Analysis Method
33
E. Research Variable Operational
40
CHAPTER IV. FINDINGS AND ANALYSIS
CHAPTER V.
REFERENCES
APPENDIX
A. General View on Research Object
44
B. Findings and Analysis
60
CONCLUSION
A. Conclusion
76
B. Implication
77
79
List of Tables
Page
Table 1.1
Company's Debt and Debt to Equity Ratio
Table 2.2
List of Previous Research
27
Table 3.3
Research's Variables and Its Indicators
40
7
List of Figures
Page
Figure 1.1
ROE Change Sensitivity upon EBIT Change
8
Figure 1.2
Directional Factor of Return on Equity Line
9
Figure 2.3
Corporation's Capital Scheme Philosophical Framework
28
Figure 2.4
Return on Equity
29
Figure 2.5
Earnings per Share
29
Figure 4.6
Elnusa
44
Figure 4.7
Aneka Tambang
46
Figure 4.8
Petrosea
47
Figure 4.9
International Nickel Indonesia
49
Figure 4.10
Radiant Utama Interinsco
50
Figure 4.11
Ti mah
53
Figure 4.12
Central Korporindo Internasional
56
Figure 4.13
Apexindo Pratama Duta
57
BIOGRAPHY
I. PERSONAL IDENTITY
1. Name
: Anda! Pradipta
2. Place and date of birth
: Jakarta, February 17, 1987
3. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
4. Phone
: 0818998628
5. Email
: pvogue@gmail.com
II. EDUCATION
I. Elementary school
: SD Baiturrahmah Padang
2. Junior high school
: SMPN 2 Padang
3. Senior high school
: SMA Pribadi Depok
III. ORGANIZATIONAL EXPERIENCE
1. Jakarta Debating Competition committee
2. Organizing committee on MoU between Intel and UIN
IV. FAMILY BACKGROUND
1. Father
: Riya:ntoko
2. Place and date of birth
: Sragen, August 2, 1955
3. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
4. Phone
: 08121033941
5. Mother
: S. Neni Budi Ratni
6. Place and date of birth
: Yogyakarta, Febrnary 17, 1960
7. Address
: JI. Karya Pemuda No.9 Beji Timur, Depok
8. Phone
: 08561108902
ABSTRACT
This study is an empirical work that investigates the effect of a firm's leverage
on returns and earnings. Writer undertakes the tests based on the explicit valuation
model of some researcher and tested in the mining industry in Indonesia. This is
consistent with the findings of Modigliani and Miller (1958). Results are robust to
other factors.
Using several measures for debt capacity, writer finds that the negative effect
is stronger for firms with limited debt capacity. Moreover, firms with an increase in
leverage ratio tend to have less futme investment, controlling for the potential
negative effect of growth option on leverage ratio.
These findings are consistent with a dynamic view of the pecking-order theory
that an increase in leverage reduces finns' safe debt capacity and may lead to future
underinvestment. Writer finds that the observed patterns are stronger for changes in
the long-term debt than that in the short-term debt and remain significant among
financially healthy firms.
of
Further, while leverage seems to be working well for few ｃｦｾｴ･ｧｯｲｩｳ＠
companies, it is affecting some others negatively. Companies that are moderately
geared i.e. in the range of gearing ratio of 50 percent to 85 percent have been able to
generate a good ROE. In a nutshell, it is the management who take the lead and
responsible for the usage of company's external somce of fund to leverage their
company as to maximize the practice.
Keywords: financial leverage, liquidity, return on equity, earnings per share, mining
industry, Indonesia
ABSTRAK
Penelitian ini adalah studi empiris yang menyelidiki efek dari hutang
perusaharu1 terhadap pengembalian modal dan pendapatan. Penulis menjalankan tes
berdasarkan model penghitungan dari beberapa peneliti yang selanjutnya di tes pada
industri pertambangan di Indonesia. Ini konsisten dengan penemuan dari Modigliru1i
dan Miller (1958). Hasilnya adalah bagus terhadap faktor-faktor lain.
Menggunakan beberapa pengukuran untuk hutang, penulis menemukan bahwa
perusahaan dengan kapasitas hutang yang terbatas mempunyai efek negatif yang
lebih kuat. Selebihnya, perusahaan dengan peningkatan dalam rasio hutang cenderung
untuk memiliki investasi masa depan yang lebih kecil, mengendalikan pertumbuhru1
yang potensial terhadap efek negatif pada rasio huta11g.
Penemuan ini konsisten denga11 pru1da11gan dinamis dari teori pecking-order
yang menyatakan bahwa peningkata11 hutang menurunkan kapasitas aman huta11g dari
perusahaa11 itu dru1 dapat berujtmg pada investasi yru1g kecil pada masa depan.
Penulis menemukan bahwa pola yang diteliti lebih kuat untuk perubahan pada huta11g
jangka pru1jang daripada lrntang jangka pendek dan tetap signifikan diantru·a
perusahaan denga11 finansial yang sehat.
Lebih jauh lagi, ketika hutang bekerja dengan baik untuk beberapa
perusahaan, temyata hutru1g memberika11 efek negatif pada perusahaa11 lain.
Perusahaan denga11 rasio hutang yang moderat yang berada dalrun rasio a11tara 50%
dan 85% bisa menghasilkan pengembalian modal yffi1g baik. Selanjutnya, adalah
ma11ajemen perusahaan yang memimpin dan bertanggung jawab terhadap
penggunaan dana ekstemal untuk operasional perusahaa11 dan memaksimalkarmya.
Kata kunci: hutang, likuiditas, pengembalia11 modal, laba bersih per sahrun, industri
pertrunbangan, Indonesia
PREFACE
In the name of Allah SWT, writer would like to say thank you for the
completion of this paper with the title "Financial Leverage and its Effect on Return
on Equity and Earnings per Share". This paper is a framework that aims to shed some
light on the financial structure of mining industry and further analyzes the impact of
leverage on it. The writer would like to say thank you to the following that have
given their support in making this paper possible:
1. My beloved parents for their great support and endless courage to help
me finishing this paper.
2. Dean Faculty of Economics and Social Sciences Drs. Faisal Badroen,
MBA.
3. Academic supervisor I Prof. Dr. Ahmad Rodoni, MM and academic
supervisor II Dr. Rofikoh Rokhim for their extremely helpful
assistance along with the consent to finish this paper.
4. Bisnis Indonesia for providing data to meet my data requirement for
my thesis.
5. All my friends in International Program as we have shared good times
together: Mamat, Abdul, Donal, Hendry, Iqbal, Savirul, Faqih, Fitry,
Tia, Erika, Aysa, Khairiyah, Kiki, Nada and everyone in the class that
could not be mentioned one by one.
6. All the staff in International Program office for handling the required
document especially Mrs. Fitri, and Mr. Syamsudin.
7. My tennis mates Bono, Sofyan, Rama; you guys rock.
8. Asus WSF for limitless contribution; my dependent partner; hail on
you.
9. My handy 2 gigabyte HP thumb drive for maximum mobile data
transfer.
l 0. Bignet for internet connection
111
KP9 to let me connect to virtual
world along with surfing for international journals.
11. Canadian corner in main library for providing cozy place to write this
paper.
12. The legendarily powerful yet efficient l ZZ-FE for making me
conveniently move from one place to another.
13. 'Attack' package to power up my energy to run the day; 3 packages at
a time is considered normal.
14. And to everyone that helped me to go through this paper.
CHAPTER I
INTRODUCTION
A. Background
Facing an open competition in the globalization age is one of the
toughest tasks for either state own enterprise or private company.
Corporations are highly obliged to offer excellent products or services
throughout the competition. Consumer will have more variety of choices to
products or services available in the market. Subsequently, it is just the matter
of time to survive in the competition; consumer will judge which product is
the best. Along with increasing market share, all firms aim to expand their
operation.
Competing in a tight competition needs accurate calculation where
every pace is vital and as important as corporation's current undertaking in
addition to future achievement. Most of the time, capital support is playing
important role to expand or survive in such rivalry (Padron, 2005:61). As
such, there are various ways for a corporation to get financing for their
operation, either internally or externally. At times, internally generated funds
will not be sufficient to finance all of the firm's proposed expenditures. In
these situations, the corporation may find it necessary to attract large amount
of financial capital externally or otherwise forgo the projects that are forecast
to be profitable (Ross, 2006:389).
At the same time, corporation is trying its best to create value added,
which is at the end will attract investors to put and invest their money in it.
From many indicators for investor, some of them are return on equity (ROE)
and earnings per share (EPS) of that particular corporation (Sunarto, 2001).
Investors are looking for the best performance stock, which is represented by
constantly increasing price or at least maintain its price at the particular range.
That point, later, indicates the profitability, as well as its return and earnings.
By doing so, they will be able to draw large amount of capital to develop their
size in terms of market share.
Information needed by investors in capital market is not only
fundamentally precise, but also technically defined (Sunarto, 2001 ).
Fundamental inf01mation is internally derived while technical information is
acquired externally, such as economy, politic, finance, and other factors.
Information obtained internally is usually taking form in financial report.
Fundamental and technical information can be used as a basis for investor to
predict return, risk, amount, time, and other factors related to activity in
cap ital market.
One of the most imp01tant concepts in all of finance deals with risk
and return. As it goes with one of the financial management principles, it says
that the risk return trade off-we will not take additional risk unless we expect
to be compensated with additional return (Keown, 2005:26). Risk is the
prospect of an unfavorable outcome. This concept has been measured
operationally as the standard deviation or beta (Keown, 2005:190). The
practice of corporate risk management has changed dramatically over the past
two decades. Originally, risk management was implemented on an
uncoordinated basis across different units of the firm. The primary focus of
these ad hoe risk management programs was to minimize costs. Today,
however, risk management of currency exposure has, in many cases, evolved
into a firmwide exercise that addresses both short-te1m and long-term
exposures and encompasses financial as well as operational hedges.
The ultimate goal of firmwide risk management is to reduce risk while
placing the firm in a position to benefit from opportunities that arise from
exchange rate changes. For example, Davis and Militello (1995) describe how
Union Carbide employs a firmwide perspective in risk management. The
company uses a one-year horizon for financial hedges (e.g., foreign-exchange
derivatives), whereas for longer horizons, operational adjustments are made in
sourcing, utilization of different plant locations, and pricing.
Firmwide risk management for multinational corporations (MNCs) is
the combination of both financial and operational hedges as part of an
integrated risk management strategy aiming at reducing exposure to foreignexchange risk (Cartera, 2001). Changes in exchange rates can influence
MNCs' current and future expected cash flows and ultimately, stock prices.
The direction and the magnitude of changes in the exchange rate on firm value
are a function of the firm's corporate hedging policy and the structure of its
foreign currency cash flows. The latter depends on the firm's competitive
position in the industries in which it operates. The fo1mer indicates whether
the MNC utilizes operational hedges and financial hedges to manage currency
exposure.
Leverage is traditionally viewed as arising from financing activities:
finns boITow to raise cash for operations. The standard measure of leverage is
total liabilities to equity. However, while some liabilities-like bank loans and
bonds issued are due to financing, other liabilities--like trade payables,
deferred revenues, and pension liabilities-result from transactions with
customers and suppliers in conducting operations. Financing liabilities are
typically traded in well-functioning capital markets where issuers are price
takers.
Compared to many areas of corporate finance, relatively little is known
about the fundamental detenninants of the expected rates of return of
individual firms-that is, how the characteristics of a paiticular firm affect
'
expected returns earned by security-holders.
Miller-Modigliani (1958; henceforth MM) argued rigorously that the
value of a firm is independent of its capital structure. The immediate
implication of Proposition I was that the return on equity capital is an
increasing function of leverage. This is because debt increases the riskiness of
the stock and hence equity shareholders will demand a higher return on their
stocks.
MM's Proposition II stated that the rate of return on common stock of
companies whose capital structure includes some debt is equal to the
appropriate capitalization rate for a pure equity stream plus a premium related
to financial risk (Sivaprasad, 2007). The impact of these propositions on
corporate finance is immense but the original sample they used is very limited.
Further empirical work uses much larger samples but results are mixed. Some
authors (Hamada, 1972; Bhandari, 1988) show that returns increase in
leverage, others show that they decrease in leverage (Dimitrov and Jain, 2005;
Penman 2007).
Financial leverage, in turn, results from a company resorting to debts.
Their role in the structure ensures a greater return on equity in the case of
prosperity, but in the case of a slump brings about greater losses, as it
increases liabilities. Each of these decisions has advantages and involves risk
at the same time. Analysis of leverage aims at providing infonnation al;>out the
advantages and risk resulting from it. By putting emphasize into financial
leverage, it is a step closer to reduce risk as well as predicting the return.
In the theory of firm's capital structure and financing decisions, the
Pecking Order Theory or Pecking Order Model was developed by Stewart C.
Myers and Nicolas Majluf in 1984. It states that companies prioritize their
sources of financing (from internal financing to equity) according to the law of
least effort, or of least resistance, preferring to raise equity as a financing
means of last resort. Hence, internal funds are used first, and when that is
depleted, debt is issued, and when it is not sensible to issue any more debt,
equity is issued. This theory maintains that businesses adhere to hierarchy of
financing sources and prefer internal financing when available, and debt is
preferred over equity if external financing is required.
Mining industry has been the main source of income for Indonesia for
a long time. Given the abundant resources, Indonesia is one of the most
attractive places for foreign investors. According to PricewaterhouseCoopers'
research, the contribution of mining industry to the economy of Indonesia in
2003 reached around Rp. 19.5 trillion, which is mostly in the form of
government income (Rp. 9.3 trillion) and purchases from local suppliers (Rp.
7.1 trillion).
Expenditure for the public interest is quite large such as for regional
I
and social development, reached around Rp. 604 billion (2003), staff training
(Rp 164 billion), research and development (US$ 1.04 million). Meanwhile,
expenditures for the reclamation, mine closure and environmental control
reached US$ 83.6 million.
The numbers of Indonesian workers absorbed by the mining industry
in 2003 came out at 33,112 people. These numbers are resulted from research
involving 33 companies that have been operating and 35 exploration
companies during 1999-2003 and do not reflect all gold and coal producers in
Indonesia. Some of them are already go public while some others have yet to
neither list their shares in stock market nor offer their shares to public. If all
the data is entered for various types of minerals industry, the numbers will
cettainly increase and affect the entire figures.
Below is the list of go public mining company in Indonesia (figures in
Rupiah expressed in thousands, data of2007):
Table I.I
Comoanv's Debt and Debt to Equitv Ratio
Company
No
Short term debt
Long term debt
DER
18,995,251,422
1,350,972,348
0.11
Bumi Resources
7,984,974,395,526
5,338,504,954,160
1.26
3
Indo Tambangraya Megah
2,245,990,428,000
755,213,882,000
0.68
4
Resource Alam Indonesia
60,762,715,000
29, 708,899,000
1.09
5
Perdana Karya Perkasa
76,675,215,684
76,785,475,234
0.88
6
Tambang Batubara Bukit
Asam
695,010,000,000
421,789,000,000
0.40
496,740,688,000
182,048,658,000
0.95
Petrosea
463,854,200,814
1,933,740,064,186
1.09
Apexindo Pratama Dula
918,095,000,000
277,169,000,000
1.26
Elnusa
3,688,450,000,000
2,337,494,000,000
1.80
Energi Mega Persada
3,548,668,475,674
10,505,938,001,544
2.85
121,440,162,625
111,038,745,798
l.29
1,798,816,747,000
1,474,300, 753,000
0.37
1
A TPK Resources
2
7
8
9
10
11
12
13
14
15
16
17
18
19
Medco Energi Internasional
Radiant Utama Interinsco
Aneka Tambang
I 94,792,000,000
114,063,000,000
1.69
Cita Mineral Investindo
2,366,059,276,000
2,339,218,588,000
0.36
International Nickel Indonesia
1,350,230,000,000
323,163,000,000
0.50
Timah
50,837,822,000
54,437,767,000
0.16
Central Korporindo Int' I
117, 166,000,000
21,315,000,000
3.29
Citatah Industri
102,024,224,000
2,680,594,000
5.33
Mitra Jnvestindo
Source: Bi.mis Indonesia
An alternative measure of overall company performance is return on
equity (ROE). A company's ROE is affected by the same income statement
items that affect ROA as well as by the company's degree of financial
leverage, which is shown as follows (Ross, 2006:467):
ROE
ROA x Leverage measure
Net income
Net income
Equity capital
Total assets
x
Total assets
Equity capital
Figure 1.1
ROE change sensitivity upon EBIT change
(Source: Tadeusz Dudycz, "The Different Faces of Leverage")
Figure 1.2 shows two variants of financing the same investment.
Variant B involves a greater contribution of debts in the capital structure, and
variant A smaller. The total capital is identical in both variants. We can see
that variant B, with respect to the size of EBIT, initially ensures a smaller
return on equity, which grows after crossing a certain value of EBIT. Variant
B also leads to a higher sensitivity of changes in return on equity to changes in
EBIT. The sensitivity depends on changes in the
J3 angle.
If we assume that, just as in the case of operating leverage, the
sensitivity of changes in return on equity (ROE) to EBIT change is a measure
of financial leverage in the static approach (independent ofEBIT value), then
on the basis of Figure 1.3 we can derive that the financial leverage FL equals:
!!.ROE
FL=wfJ· = - -·
f!.EBIT
}{_()
/
.dROE
Figure 1.2
Directional factor (slope) ofretum on equity line
(Source: Tadeusz Dudyez, "The Different Faces of Leverage")
The leverage measure is simply the inverse of the capital ratio (when
only equity counts as capital). The higher the capital ratio, the lower the
leverage measure and degree of financial leverage.
It is also important to look for a financial capital to extend the
capacity. Thus, due to the increasing of credit by commercial banks, it is
natural that financial leverage plays important role on the development of a
firm. While exercising financial leverage, the cost of that leverage is also
increasing. This is also affecting net income, ROE, and BPS of that particular
firm.
This paper contributes to the existing literature on the relationship of
returns and capital structure in three directions. First, this is a study which
expands the limited work carried out on leverage and returns by examining
leverage as an independent variable and its impact on returns. Second, the
paper tests for linearity of leverage and return. This is an important testI to
enable the better understanding of the traditionalist theory of capital structure
and optimal capital structure. Thirdly, the writer undertakes robustness checks
with several factors.
The definitions of financial leverage used in corporate finance
textbooks vary, but most textbooks discuss this result, and the explanation
offered for a positive relationship between financial leverage and the expected
rate of return is usually along the same lines. All else equal, a firm with high
financial leverage has high external financial capital and low internal capital,
so that the additional revenue from one additional unit of production is offset
by a relatively small increase in leverage cost.
B. Problem Identification
Attracting and convincing investors have never been easy for it ties
with company's value, performance, goodwill, as well as its reputation. It is
also important to know the relation between financial leverage and ROE along
with EPS. Therefore, corporation can consider how large in taking external
financing to can-yon their operation.
In fact, each and every year, under certain condition, there is always
corporation with the closest relation on the topic chosen for the research: the
higher the financial leverage, the higher the ROE and EPS (Pamela, 2006).
Based on the background explained previously, the writer wants to focus on
the problem needs to be addressed which is impact of leverage in terms of its
effects on ROE and EPS in mining industry. Aside from main focus of the
problem, there are also other problems:
1. Does financial leverage and liquidity affect ROE for listed mining
company in Indonesia Stock Exchange from year 2005-2007?
2. Does financial leverage and liquidity affect EPS for listed mining
company in Indonesia Stock Exchange from year 2005-2007?
C. Purpose and Significance
I. Purpose
This research seeks to analyze relation between financial leverage
and ROE as well as EPS. The aims of the paper are:
a. To examine the significance of financial leverage and liquidity towards
ROE for listed mining company in Indonesia Stock Exchange from
year 2005-2007.
b. To examine the significance of financial leverage and liquidity towards
EPS for listed mining company in Indonesia Stock Exchange from
year 2005-2007.
This paper also presents a twofold approach to the measurement of
leverage: static and dynamic, which give two separate parameters
providing the company board with different information. By this research,
expectantly it will bring benefit to those who needed it especially for
mining industry in this country.
2. Significance
Separately, there are various conditions that later influence the
significance of the research:
a. Academically,
this research expects the contribution for the
development of lmowledge and general information on effect of
leverage in mining industry, and parties related to the problem of
research.
b. Practically, this research offers initiative for corporation, particularly
mining company, related to the problem ofresearch.
c. Socially, this research provides idea that keenly brings changes in the
way people think, act, as well as providing general knowledge for
society.
d. Technically, this research tries to make a good study of both the
concept and methodology on top of the entire research activity. On the
other hand, it is also possible that this research is used as a basis
reference for next research with related topic.
CHAPTER II
LITERATURE REVIEW
A. Company Sources of Fund
Sources of fund for a company in general include the following
(Husnan, 1994):
I. Internal
a. Retained earning, influenced by:
l) Amount of earning in that particular period
2) Dividend policy
The higher the dividend, the lower the retained earnings. Vice
versa.
3) Reinvestment
b. Depreciation accumulation
2. External
a. Debt, classified as follows:
I) Short term debt(< I year)
2) Mid term debt (I-JO years)
3) Long term debt(> I 0 years)
b. Owners' equity
Equity from owners of the company for limitless time. Accordingly, it
is an equity being staked for all business risk as well as other risk.
Sources of financing from owners' equity:
I) Common stock
It represents the ownership in a company. Common stock does not
have a maturity date, but exists as long as the firm does. Nor does
common stock have an upper limit on its dividend payment. The
common shareholders have the right to the residual income after
bondholders and preferred stockholders have been paid.
2) Preferred stock
Security with characteristics of both common stock and bonds. It is
similar to common stock because it has no fixed maturity date, the
nonpayment of dividends does not bring on bankruptcy, and
dividends are not deductible for tax purposes. Preferred stock is
similar to bonds in that dividends are limited in amount.
3) Cumulative preferred stock
Basically, cumulative preferred stock is the same as preferred
stock. What makes them different is that the earlier has cumulative
right, wherein the company does not generate profit for some
period, dividend will be suspended until the company generates
profit. It requires all past unpaid preferred stock dividends to be
paid before any common stock dividends are declared.
B. Financial Leverage
The study of the combination of internal and external financial
resources in company liability has generated controversy over the years.
Especially significant is Miller and Modigliani's (Ml\i!) important contribuuion
to capital structure theory of 195 8, which showed that, given a company's
investment policy, and not taking taxes and transaction costs into account, the
choice of financial policy does not affect the current market value of the
company. However, because real markets are far from the so-called "perfect
capital markets" on which MM based their work, numerous studies have
shown the interdependence among investment decisions, financing decisions,
and fitm value. Continued interest in this topic justifies further study of a
company's financial decisions that determine its level of debt.
In MM tests of proposition II, returns to shareholders are approximated
by actual shareholder net income and estimations are made in the cross section
of all firms in a risk class for a single year. As the authors discuss amongst
themselves, this is very crude. The writer uses panel data that contains
information for three consecutive years and combines the cross section with
the time series. The writer represents returns to shareholders as stock returns
in excess of risk-free rate.
MM defined leverage as ratio of the market value of bonds and
preferred debt to the market value of all securities; the writer measures
leverage as the ratio of the book values of total debt to total capital. Leverage
based on book values is associated with lower average returns, whereas
leverage based on market is associated with higher returns (Fama and French,
1992; henceforth FF). He concluded that this variation in their findings is
explained and absorbed by the book-to-market effect. In MM, the only
independent variable is the leverage ratio to test for the linearity of the
relationship. In this study, on top of the leverage ratio, the writer uses
variables that reflect average leverage in every risk class and idiosyncratic
risk, including the FF risk factors.
Investigation has been done on the relationship between leverage and
returns (Arditti, 1967). He defined returns as the geometric mean of returns
and leverage was defined as the ratio of debt measured in book value to equity
measured at market value. He found leverage to have a negative sign in the
regressions-though insignificant-to returns. He argued that the negative
relationship is because there are inter-firms risks which are not accounted for
by the probability distribution variables. Others also examined the relationship
between leverage and returns (Hall, 1967). He defined returns as profits after
tax and ratio of equity to assets as an indicator for leverage. His results show
that equity to assets was positively related to returns, indicating that returns
have an inverse relationship with returns. This was because large amounts of
leverage (i.e. low equity to assets) imply high risks, and hence profitable firms
take some of the exceptional returns in the form of reduced risks. Another
researcher also undertook an examination of the effect of leverage on industry
returns (Baker, 1973). He measured leverage inversdy as the ratio of equity to
total assets for the leading firms in an industry over the he year period. He too
found that relatively large amounts of leverage tend to raise industry profit
rates, more leverage implying greater risks. In this study, in addition to Ithe
leverage ratio and its square, the writer uses three variables that reflect
leverage, including its ratio and the particular return and earnings.
From various financial ratios, there are some ratios and corporate
financial information that can be used to predict return. Financial ratio is
divided into five categories (Ang, 1997): (I) liquidity ratio; (2) activity ratio;
(3) profitability ratio; (4) leverage ratio; and (5) market ratio. Profitability
ratio consists of seven ratios: gross profit margin (GPM), net profit margin
(NPM), operating return on assets (OPROA), return on asset (ROA) or return
on investment (ROI), return on equity (ROE), and operating ratio (OPR).
Leverage ratio is divided into eight different ratios: debt ratio, debt to
equity ratio, long-tenn debt to equity ratio, long-term debt to capitalization
ratio, times interest earned, cash flow interest coverage, cash flow to net
income, and cash return on sales (Ang, 1997: 18). Leverage ratio shows how
large debt ratio which is ratio from total debt to total assets.
C. Liquidity
Liquidity is the speed and ease at which an asset can be converted into
cash. The more cun-ent assets that a firm has relative to its current liabilities,
the greater the firm's liquidity (Keown, 2005:41). Or else, the ability of a firm
to pay its bills on time. Measuring a firm's liquidity is not an easy task, for it
has two approaches. The first approach compares cash and the assets that
should be converted into cash within the year. The assets here are the current
assets, and the debt is the current liabilities in the balance sheet. The current
ratio measured by its current assets relative to its current liabilities.
Furthermore, remembering that the three primary current assets include cash,
accounts receivable, and inventories, it is possible to make the measure of
liquidity more restrictive by excluding inventories, the least liquid of the
current assets, in the numerator. This revised ratio is called acid-test ratio.
The second approach of liquidity examines the firm's ability to convert
accounts receivable and inventory into cash on a timely basis (Keown,
2005:75). The conversion of accounts receivable into cash may be measured
by computing how long it takes to collect the firm's receivables; that is, how
many days of sales are outstanding in the form of accounts receivable. It can
be answered by computing the average collection period, which indicates how
rapidly a firm is collecting its credit, measured by the average number of days
it takes to collect its accounts receivable. It could be the same conclusion by
measuring how many times accounts receivable are "rolled over" during a
year, or the accounts receivable turnover ratio, measured by the number of
times its accounts receivable are collected during a year.
As a general rule, management would want to collect receivables
sooner rather than later-that is, reduce collection period and increase
inventory turnover. However, it may be that a company's management would
intentionally extend longer credit terms as a policy for reasons it deems
justifiable. Alternatively, slower collection could mean that management is
simply not being as careful at enforcing its collection policies. In other words,
it may not be managing receivables effectively. Some people may want to
know the same thing for inventories that is just determined for accounts
receivable: How many times are a firm turning over inventories during the
year? In this manner, some insight can be gain into the liquidity of inventories.
The inventory turnover ratio indicates the relative liquidity of inventories, as
measured by the number of times a firm's inventories are replaced during the
year.
The impact of the liquidity of a firm's assets on optimal leverage has
been a source of debate for many years. Williamson (1988) and Shleifer and
Vishny (1992) predict that asset liquidity increases optimal leverage, while
Morellec (200 l) and Myers and Rajan (1998) argue that its effect is negative
or curvilinear. The rationale for a positive effect of asset liquidity on leverage
relies on the idea that less liquid assets sell at higher costs, which increases the
costs of liquidation, bankruptcy, and debt. Lower asset liquidity therefore
creates the need to reduce the probability of costly default by lowering the
leverage. Yet models that predict a non-positive effect argue that lower asset
liquidity makes it more costly for managers to expropriate value from
bondholders. Thus, lower asset liquidity reduces the costs of debt, and as a
result, companies use more debt. Despite substantial progress in modeling the
relation between asset liquidity and leverage, limited empirical evidence
pertains to this effect because of the difficulty of obtaining a measure of asset
liquidity. In turn, existing studies that examine the relation between asset
liquidity and leverage - such as Alderson and Betker (l 995), Kim (1998), and
Benmelech, Garmaisc, and Moskowitz (2005) - tend to limit their attention to
narrow and specific samples offinns or assets.
Merton (1987) states that relatively larger firms will have a greater
trading interest since more individuals and institutions will have positions in
the firm. Larger films will also be more carefully scrutinized by both
professional and unsophisticated analysts. The increased information
gathering makes prices more efficient, thereby reducing adverse selection
costs. By providing a larger pool of trades to offset adverse selection costs,
increases in the breadth of ownership, paiticularly smaller shareholders, can
offset additional adverse selection costs and lead to reduced spreads. We
therefore expect increases in finn size, volume, and the number of
shareholders to be negatively related to changes in spreads.
The expected impact of corporate diversification on liquidity is
unclear. There are arguments and evidence supporting both a positive and
negative relationship between diversification and liquidity. Chang and Yu
(2004) suggest diversified firms have reduced adverse selection costs since
firm-level prices are less sensitive to information asymmetries arising in
individual divisions. In addition, Benston and Hagerman (1974) point out that
since market makers hold undiversified portfolios, corporate diversification
reduces inventory holding costs by reducing volatility. The reduction in either
adverse selection costs or inventory holding costs would reduce spreads for
diversifying firms. Alternatively, Nanda and Narayanan (1999) suggest that
allowing each of a diversified firm's divisions to trade independently
facilitates price discovery by investors. More accurate market prices would
mitigate adverse selection problems and improve liquidity. Note that price
discovery arguments do not preclude offsetting diversification effects.
D. Return on Equity
There are only three ratios from profitability ratio that have
significance on the corporation's profit forecast for a year ahead (Machfoedz,
1994). Those three ratios are: GPS, NIS, and NINW. GPS is usually stated as
gross profit margin (GPM), NIS also acknowledged as net profit margin
(NPM), and net income to net w01th (NINW) as return on equity (ROE).
Furthermore, from the three ratios, the only ratio that has significant relation
(1%) with earning prediction is net income to net worth (NINW) or retnrn on
equity (ROE) (Machfoedz, 1994).
The financial structure of a corporation provides the market with
information about the firm, with the market value of the firm increasing with
the level of debt (Ross, 1977). This can be taken to mean that, if managers
raise the level of debt, then it is because their expectations for the future of the
company permit it to meet its obligations, making it clear that the risk of
insolvency is not relevant. The value of a company and the size of its debt are
positively correlated (Raviv, 1990). Variations in the company's level of debt
will affect its market value, since the firm's change in capital structure
transmits information about the future expectations of the company. For
example, an announcement of the reduction of the number of common stocks
in exchange for a debt offering has a positive effect on the market, which
becomes a negative effect when the reverse happens (Copeland and Lee,
1991).
There is a positive relationship between stock retnrns and leverrge
(Hamada, 1972; Bhandari, 1988). Both test the relationship in the cross
section of all firms. Calculation on returns as profits after taxes and interest
which is the earnings the equity and preferred shareholders receive on their
investment for the period (Hamada, 1972). The \'