SUBMITTED FOR PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR UNDERGARDUATE DEGREE OF ACCOUNTING DEPARTEMENT OF ACCOUNTANCY ACCOUNTING STUDY PROGRAM

THE ENHANCEMENT DECISION THROUGH INVESTMENT OPPORTUNITY SET (IOS): EVIDENCE TO LEVERAGE, DEBT MATURITY, AND PROTECTIVE COVENANT UNDERGRADUATE THESIS SUBMITTED FOR PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR UNDERGARDUATE DEGREE OF ACCOUNTING DEPARTEMENT OF ACCOUNTANCY ACCOUNTING STUDY PROGRAM SUBMITTED BY: YULLIANA EKANINGRUM NIM: 040913021 FACULTY OF ECONOMIC AND BUSINESS AIRLANGGA UNIVERSITY SURABAYA 2013

  

SKRIPSI THE ENHANCEMENT DECISION ... YULLIANA EKANINGRUM

  

SKRIPSI THE ENHANCEMENT DECISION ... YULLIANA EKANINGRUM

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  ACKNOWLEDGMENT

  By all praise and thanks for Allah SWT, for all the plenty of rahmat and hidayah, protection, rescue, and blessings to me so that I can finish this undergraduate thesis on time, and also the accompaniment of salam and sholawat for the Prophet Muhammad SAW. Alhamdulillah I finally able to finish my undergraduate thesis entitled “THE ENHANCEMENT DECISION THROUGH

  IOS: EVIDENCE TO LEVERAGE, DEBT MATURITY, AND PROTECTIVE COVENANT” as partial fulfillment of the requirement to obtain bachelor degree of economics in accounting major at Airlangga University.

  In the completion process of this undergraduate thesis, a lot of supports, assistance, and motivation has been given to me. I would like to gratefully acknowledge with gratitude to:

  1. Mr. Prof. Dr. Muslich Anshori, SE., Msc., Ak., as the Dean of Economics and Business Faculty, Airlangga University.

  2. Mr.. Drs. Agus Widodo Mardijuwono, M.Si., Ak. As the Head of Accounting Study Program, Economic and Business Faculty, Airlangga University.

  3. Dr. H. Zaenal Fanani, SE., MSA., Ak. as great supervisor, for the invaluable assistances, supports, directions, advises, and time given in this completion of undergraduate thesis. I do really deeply thanks for all the aids and supports.

  4. Drs. H. Djoko Dewantoro, MSi., Ak., who has been guiding me in college activities until I am graduated.

  5. All lectures in Airlangga University, for valuable teachings that have been given that helped me to improve my knowledge and thought in many ways.

  6. My beloved parents, Mitro Hadi Seputro and Wilarni, who always understand, give me huge supports, loves and the best wishes for me. And my lovely brothers, Muhammad Dwikurniawan and Mahendra Triatmaja for always cheering me up.

  7. My beloved Herlambang Setiadi, thank you for the aid in looking for references, supports, great loves, understandings, and wishes.

  8. All of the great and super English Class students, thank you for the wonderful moments that occurred in the past few years and thanks for helping me in shaping up my idea and research.

  9. To whom has important role to the completion of my undergraduate thesis, as well as expressing my apology that I could not mention personally.

  May Allah SWT gives protection and blessing to all of the party. Hopefully, this research can give contribution for the development of accounting knowledge.

  Surabaya, February 2013 Researcher v

  ABSTRACT

  The existences of investment opportunity that lead to deal in financing decisions are potential appearing agency conflicts. Some of the former empirical evidences revealed that the consideration of investment opportunity in the choice of leverage, debt maturity and protective covenant can be one of efforts in controlling agency conflict respectively. This study investigates the influence of investment opportunity set (IOS) towards leverage, debt maturity and protective covenant. The sample of the research is non-financial companies that are listed in Indonesia Stock Exchange, issuing and publishing bond instrument, and having positive equity for the year 2009 until 2011. This research uses confirmatory factor analysis (CFA) in the measurement of IOS and protective covenant in accordance providing more accurate and comprehensive measurement in these variables. By using linear regression method, the findings of this research are, IOS has a negative significant effect towards leverage. Meanwhile, IOS has no significant effect towards debt maturity. Moreover, IOS has a positive influence towards protective covenant.

  Keywords: agency conflict, investment opportunity set, leverage, debt maturity, protective covenant, confirmatory factor analysis

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  LIST OF CONTENTS Title Page ................................................................................................................ i Validation Sheet ................................................................................................... ii Thesis Originality Declaration............................................................................ iii Acknowledgment ................................................................................................. iv Abstract................................................................................................................. vi List of Contents. .................................................................................................. vii List of Tables ....................................................................................................... xii List of Figures..................................................................................................... xiii List of Appendix ................................................................................................. xiv

  CHAPTER 1: INTRODUCTION

  1.1. Research Background ...................................................................................... 1

  1.2. Problem Formulation ....................................................................................... 7

  1.3. Research Objectives ......................................................................................... 7

  1.4. Research Contributions .................................................................................... 7

  1.5. Research Systematic ........................................................................................ 8

  CHAPTER 2: LITERATURE REVIEW

  2.1. Theoretical Review ........................................................................................ 10

  2.1.1. Theory of Agency ................................................................................. 10

  2.1.1.1. Agency Theory of Outside Equity ............................................ 12

  2.1.1.2. Agency Theory of Debt ............................................................ 14

  2.1.2. Theory of Investment Opportunity Set ................................................. 15

  2.1.3. Variables in this Research..................................................................... 18 vii

  viii

  2.2. Previous Research .......................................................................................... 33

  3.2. Variable Identification ................................................................................... 54

  3.1. Research Approach ........................................................................................ 54

  CHAPTER 3: RESEARCH METHODOLOGY

  2.4.3. The Influence of Investment Opportunity Set towards Protective Covenants ............................................................................................. 52

  2.4.2. The Influence of Investment Opportunity Set towards Debt Maturity . 51

  2.4.1. The Influence of Investment Opportunity Set towards Leverage ......... 49

  2.4. Hypothesis...................................................................................................... 49

  2.3. Conceptual Framework .................................................................................. 47

  2.1.3.7. Firm Size ................................................................................... 32

  2.1.3.1. Leverage.................................................................................... 18

  2.1.3.6. Profitability ............................................................................... 31

  2.1.3.5. Fixed Asset Ratio ...................................................................... 30

  2.1.3.4.1. Proxy Variables for Firm’s Investment Opportunity . 28 2.1.3.4.1.1. The Market-to-Book Assets Ratio ........... 29 2.1.3.4.1.2. Market-to-Book Equity Ratio .................. 30

  2.1.3.4. Investment Opportunity Set (IOS) ............................................ 28

  2.1.3.3.2. Classification of Protective Covenants ...................... 22

  2.1.3.3.1. Definition of Protective Covenants............................ 20

  2.1.3.3. Protective Covenants ................................................................ 20

  2.1.3.2. Debt Maturity............................................................................ 19

  3.2.1 Independent Variable ............................................................................. 54

  3.2.2. Dependent Variables ............................................................................. 55

  3.2.3. Control Variables .................................................................................. 55

  3.3. Operational Definition and Measurement...................................................... 55

  3.3.1. Investment Opportunity Set .................................................................. 55

  3.3.2. Leverage................................................................................................ 58

  3.3.3. Debt Maturity........................................................................................ 59

  3.3.4. Protective Covenant .............................................................................. 60

  3.3.5. Fixed Assets .......................................................................................... 62

  3.3.6. Profitability ........................................................................................... 63

  3.3.7. Firm Size ............................................................................................... 63

  3.4. Type and Source of Data................................................................................ 64

  3.5. Population and Sampling Method.................................................................. 64

  3.6. Data Technique Analysis ............................................................................... 65

  3.6.1. Steps of Data Technique Analysis ........................................................ 65

  3.6.2. Confirmatory Factor Analysis (CFA) ................................................... 66

  3.6.3. Model of Analysis................................................................................. 68

  3.7. Criteria of Hypothesis Testing ....................................................................... 68

  3.8. Classical Assumption Test ............................................................................. 69

  3.8.1. Multicollinearity Test............................................................................ 69

  3.8.2. Autocorrelation Test ............................................................................. 70

  3.8.3. Heteroscedasticity Test ......................................................................... 70

  3.8.4. Normality Test ...................................................................................... 71

  CHAPTER 4: RESULT AND DISCUSSION

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  x

  4.2.1.7. Debt Maturity............................................................................ 78

  4.4. Analysis of Hypothesis Testing ..................................................................... 87

  4.3.4. Normality Test ...................................................................................... 87

  4.3.3. Heteroscedasticity Test ......................................................................... 86

  4.3.2. Autocorrelation Test ............................................................................. 85

  4.3.1. Multicollinearity Test............................................................................ 84

  4.3. Classical Assumption Test ............................................................................. 84

  4.2.3. The Result of Protective Covenant Confirmatory Factor Analysis ...... 80

  4.2.2. The Result of Investment Opportunity Set Confirmatory Factor Analysis .............................................................................................................. 79

  4.2.1.8. Protective Covenant .................................................................. 78

  4.2.1.6. Leverage.................................................................................... 77

  4.1. Description of Research’s Object .................................................................. 72

  4.2.1.5. Firm Size ................................................................................... 77

  4.2.1.4. Profitability ............................................................................... 77

  4.2.1.3. Fixed Assets Ratio .................................................................... 76

  4.2.1.2. Market-to-book Equity Ratio .................................................... 76

  4.2.1.1. Market-to-book Asset Ratio...................................................... 75

  4.2.1. Descriptive Statistic .............................................................................. 75

  4.2. Description of Research’s Result................................................................... 75

  4.1.2. Non-Financial Company ....................................................................... 73

  4.1.1. Indonesia Stock Exchange .................................................................... 72

  4.5. Discussion of the Result................................................................................. 90

  4.5.1. The Influence of Investment Opportunity Set towards Leverage ......... 90

  4.5.2. The Influence of Investment Opportunity Set towards Debt Maturity . 92

  4.5.3. The Influence of Investment Opportunity Set towards Protective Covenants ............................................................................................. 94

  

CHAPTER 5: CONCLUSIONS, SUGGESTIONS AND IMPLICATIONS

  5.1. Conclusions.................................................................................................... 95

  5.2. Limitations ..................................................................................................... 96

  5.3. Suggestions .................................................................................................... 96

  5.4. Implications.................................................................................................... 96

  LIST OF REFERENCES ................................................................................... 98 APPENDIX .......................................................................................................... xv

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  LIST OF TABLES

Table 2.1. Classification of Covenants ................................................................. 24

  Table 2.2.The Established Classification of Covenants in this Research ............. 27

Table 2.3. Previous Research Results ................................................................... 40Table 3.1. Types of Protective Covenants ............................................................ 61Table 3.2. The Determination of Sampling .......................................................... 65Table 4.1. The List of Subsectors of Non-Financial Companies in IDX.............. 73Table 4.2. Statistic Descriptive of Research Variables......................................... 75Table 4.3. Confirmatory Factor Analysis of IOS.................................................. 79Table 4.4. Confirmatory Factor Analysis for 5-Classifications of Covenant

  Indicators .............................................................................................. 82

Table 4.5. Confirmatory Analysis Factor of Protective Covenants ...................... 83Table 4.6. Multicollinearity Test .......................................................................... 85Table 4.7. The Result of Durbin-Watson Test ...................................................... 85Table 4.8. White’s Test ......................................................................................... 86Table 4.9. Kolmogorov-Smirnov Z Test............................................................... 87Table 4.10. The Results of Regression ................................................................. 88 xii

  LIST OF FIGURES

Figure 1.1. Domestic and Foreign Direct Investment Realization in Indonesia ..... 1Figure 2.1. Research Framework .......................................................................... 48Figure 4.1. The Result of Confirmatory Factor Analysis of Event-Driven

  Covenant ............................................................................................. 81 xiii

  LIST OF APPENDIX

  APPENDIX A: List of Companies Sample .......................................................... xv APPENDIX B: Market-to-Book Assets Ratio ..................................................... xvi APPENDIX C: Market-to-Book Equity Ratio..................................................... xix APPENDIX D: Leverage Ratio ......................................................................... xxii APPENDIX E: Resuming of Weighted Average of Debt Maturity ................... xxv APPENDIX F: Index of Protective Covenant ................................................... xxvi APPENDIX G: Fixed-Assets Ratio ................................................................. xxviii APPENDIX H: Profitability Ratio.................................................................... xxxii APPENDIX I: Firm Size.................................................................................. xxxix APPENDIX J: Descriptive Statistic..................................................................... xlii APPENDIX K: Confirmatory Factor Analysis of Investment Opportunity Set . xliii APPENDIX L: Confirmatory Factor Analysis of Restriction of Payouts to

  Equityholders and Others......................................................... xliv APPENDIX M: Confirmatory Factor Analysis of Restriction of Payouts

  Financing Activities .................................................................. xlv APPENDIX N: Confirmatory Factor Analysis of Restriction of Changing

  Business Form and Structural................................................... xlvii APPENDIX O: Confirmatory Factor Analysis of Event-Driven Covenants .... xlviii APPENDIX P: Confirmatory Factor Analysis of Restriction of Investment Policy and Asset Sales ...................................................................... xlviii APPENDIX Q: Confirmatory Factor Analysis of Protective Covenants ................ l xiv

  APPENDIX R: Regression of Investment Opportunity Set towards Leverage .... lvi APPENDIX S: Regression of Investment Opportunity Set towards Debt Maturity ................................................................................................................................ lx APPENDIX T: Regression of Investment Opportunity Set towards Protective

  Covenants .................................................................................... lx APPENDIX U: White’s Test .............................................................................. lxiv xv

  CHAPTER 1 INTRODUCTION

1.1. Research Background

  The main company goal is increasing the value of the company. The investment decision and financing decision have the important role in the enhancement of company value. Recent years, Indonesia is increasingly balancing investment growth with domestic consumption which has been the primary growth driver in recent years. A good incremental in investment depicts good incremental in investment opportunity, the industrial sectors are expected to reap the benefits in this condition.

Figure 1.1 Domestic and Foreign Direct Investment Realization in Indonesia

  Source: (Economist Intelligence Unit (2012) in Sitorus and Avianti (2012)) Generally, company needs funds to finance the investment decision. The numerous financing decisions are vital for the financial welfare of the company.

  An incorrect decision about the capital structure may lead to significant financial distress, then in all likelihood eventually result in bankruptcy.

  1 Concerning the financing activities of a company, it can obtain the fund whether from internal and external source. First, it comes from the internal sources, such as the issuance of stock and retained earnings. Second, it is derived from external sources of the company in the form of a debt from a third party.

  Regardless the size of the company, usually the companies choose to use the fund from outside the company in the form of debt because it is cheaper than equity.

  Debt is being a cheaper source of fund as compared to equity. Generally, by dealing on debt through issuance of bonds is cheaper than raising equity through a share issue. A major advantage is that the return on debt (interest) is tax-deductible, whereas the return on equity (dividends) is paid out of a company’s profits, which are taxed before dividend payments can be made to stockholders. Financing by raising debt is a useful way of monitoring a corporation’s overall health, as the ability to repay the debt reflects the overall financial stability of the company (QFinance, 2012).

  Regarding investment decision, if the company has improper decision in dealing investment opportunity, then it can cause overinvestment problem or underinvestment problem. Generally, overinvestment problem occurs in the company that has low investment opportunity have low growth level, but have large free cash flow and assets in place. The main problem is in the different perspectives between manager and stockholder in allocating the capital excess (Myers, 1977). The agency conflict of outside equity between manager and stockholder has appeared. Manager tends to invest the capital excess to risky projects while stockholders insist that the capital excess should be distributed as dividends (Jensen 1986). The improper decision in exercising the investment opportunities and financing the investment could bring harmful for the company.

  These faults could stimulate the agency conflict within company that can decrease the firm value and leads to financial distress.

  Otherwise, underinvestment problem generally occur in the company that has high investment opportunities, high growth rates, active conducting investment, low cash flow and smaller assets in place. Myers (1977) explains that the underinvestment problem occurs when firm with high investment opportunities is facing opportunities to invest in positive NPV projects that require the higher usage of funds, whereas the company only has low cash flow and assets in place. In addition, if company takes the new project by dealing on debt as financing, that is also susceptible in appearing agency conflict of debt between stockholders and bondholders. Stockholders insist that profits should be distributed as dividend, while bondholders want that profits should be used to pay off debt. As consequences, the mix of assets in place and investment opportunities influences a firm’s capital structure, especially for debt policy.

  This research investigate the influence of investment opportunity towards debt policy that is classified into three components: leverage, the debt maturity and covenant structure of its debt contracts. Leverage is commonly described as the use of borrowed money to make an investment (Bhatti et al., 2010). Debt

  maturity is the period of time for which a bond remains outstanding (Investorwords, 2012). Covenants are contracts aimed at borrowers by creditors to

  limit activities that may damage the value of loans and recovery loans (Cochran,

  2001). In Indonesia, covenants must be involved in trusteeship agreement, trusteeship agreement is agreement between the issuers (companies that issue the bonds) and trustee regarding the issuance of bond in the form of notary deed (Kep-412/BL/2010). The trustees act as a party representing the interests of bondholders as well as providing protection to them (UU No. 8 Year. 1995 about Capital Market, article 1).

  Some researchers have investigated the enhancement decision in financing and controlling the agency conflicts. Billett et al. (2007) and Fatmasari (2010) investigates the influence of growth opportunity towards the choice of leverage, debt maturity and covenants. They also observe whether covenant could attenuate the relation between investment opportunity and leverage as well as debt maturity.

  Billett et al. (2007), Fatmasari (2011), Goyal et al. (2002), Sari (2011), as well as Singhania and Seth (2010) find that direct effect of growth opportunities on leverage is negative. In addition, Awan et al. (2010) and Bulan (2008) investigate that there is a positive correlation between the growth opportunities and debt levels for the segments of firms with low and medium growth opportunity, and negative relation between debt level in high growth opportunity.

  Barclay and Smith (1995), Barclay et al. (2001), Billett et al. (2003) and Fatmasari (2011) find that investment opportunity has strong negative influence towards debt maturity, this concludes that firms with high investment opportunity use larger proportions of short-term debt in their capital structures. Otherwise, Dang (2010), Abdullah (2005), Childs, et al (2005) find that investment opportunity does not have significant influence towards debt maturity. Billett et al. (2007), Fatmasari (2011) and Sari (2011) find a positive relation between growth opportunities interacted with covenant protection.

  This research is encouraged by the reasons of there are inconsistencies in the research finding, hence the researcher want to reexamine the influence of investment opportunity set (IOS) towards leverage, debt maturity, and protective covenants by using more accurate and comprehensive indicators through confirmatory factor analysis (CFA). The sample of this research is non-financial companies listed in Indonesia Stock Exchange (IDX) for 2009 until 2011.

  This research uses confirmatory factor analysis in measuring investment opportunity set and protective covenant in accordance confirming the measured variables for a latent variable. It is a statistical approach involving finding a way of condensing the information contained in a number of original variables into smaller set of dimensions (factors) (Jairo, 2008). Thus, in measuring investment opportunity set and protective covenants, these research models use more than one indicator in construction of a variable in accordance obtaining results that are more accurate. Ecker et al. (2006) asserts that any various single measurements can be the less accurate measurement in research settings. By using various indicators through confirmatory factor analysis, hence the measurement be more accurate and comprehensive.

  Investment opportunity set is typically unobservable by outsiders, hence investment opportunity rely on various proxy variables (Adam and Goyal, 2007).

  The proxy of investment opportunity set is different among researches. Billett et al. (2007) measured the growth opportunity by using market-to-book asset ratio and Fatmasari (2010) used capital-expenditures-to-total-assets (CAXBVA) ratio. Moreover, Adam and Goyal (2007) used four investment opportunity measurements, which are market-to-book asset (MBA) ratio, market-to-book equity (MBE) ratio, earnings-price ratio, and capital-expenditure-to-plant- property-and-equipment (CAXNPPE) ratio. From those proxies, this research is strongly motivated to use market-to-book asset ratio and market-to-book equity ratio, because these are the most of two significant proxies related to growth opportunity (Adam and Goyal, 2007). Then, MBA and MBE ratio are composited to construct investment opportunity set as independent variable.

  Moreover, most of companies also involve many covenants in their trusteeship agreement. Billett et al. (2007) list 15-covenants, moreover Fatmasari (2010) lists 24-covenants. This research use 15-covenants that are adapted from the combination of Billett et al. (2007) and the covenant listed in trusteeship agreement. These 15-covenants are composited become five classifications: 1) Restrictions on Payouts to Equityholders and Others, 2) Restrictions on Financing Activities, 3) Restriction on Changing Business Form and Structural, 4) Event- Driven Covenant, 5) Restriction on Investment and Asset Sales. If all classifications fill the requirement of confirmatory factor analysis, hence the five classifications are composited to construct protective covenant as dependent variable (Y3.)

  The difference economic conditions in different countries motivate the researcher to replicate the previous research of Billett et al. (2007), based on the economic condition and fluctuation of Indonesia Stock Exchange. The researcher also wants to examine the consistency of the prior research result with take the research object from non-financial companies. Hence, this research is expected can obtain results that applicable in Indonesia.

  1.2. Problem Formulation

  Based on the problems background described above, the formulation of the problem are:

  1. Does the investment opportunity set have an influence towards leverage?

  2. Does the investment opportunity set have an influence towards debt maturity?

  3. Does the investment opportunity set have an influence towards covenants?

  1.3. Research Objectives

  In accordance with the identification of problems that have been described, the author intends to obtain data and information relating to research the issue to achieve the purpose of the study as follows:

  1. To investigate the influence of investment opportunity set towards leverage.

  2. To investigate the influence of investment opportunity set towards debt maturity.

  3. To investigate the influence of investment opportunity set towards covenants.

  1.4. Research Contributions

  By doing this research, there are several beneficial contributions expected by the author.

  1. Contribution for Theory.

  This research enhances the theory about the effect of investment opportunity set (IOS) towards leverage, debt maturity, and covenants. In this case, the author improves by using more accurate and comprehensive indicators through confirmatory factor analysis (CFA).

  2. Contribution for Empirical These research results are going to be expected can provide information to corporation, in accordance the measurement of investment opportunity set within company shall be considered in enhancing the capital structure, specifically for debt. This research is also expected can be reference for the next research within a field.

  3. Contribution for Policy The results of this research aim to provide information to the companies that the certain conditions of investment opportunity set within company can be considered as one of the necessary factor in arrangement of leverage policy, debt maturity and covenant, in accordance enhancing decision in financing.

1.5. Research Systematic

  This research is systematically compiled in the following order:

  CHAPTER 1: INTRODUCTION This part contains of elucidation the research background, problem formulations, which construct what is going to be the specific discussion in this research, and the research motivation explores the logical reason and urgency of the choice to investigate this topic.

  CHAPTER 2: THEORETICAL REVIEW This section contains of theories and previous research results used to support the topic discussion and examine the developed hypotheses. Moreover, the conceptual framework is built in this chapter to elucidate the brief flows of logical thinking of the research

  CHAPTER 3: RESEARCH METHODOLOGY This chapter explains the method approached, operational definition of variables and measurement, determination of population and sample, as well as the data analysis technique which are used to examine the hypotheses which provide assurance for the validity of research results.

  CHAPTER 4: RESULTS AND ANALYSIS The description of the result will be explained in this chapter, together with research data, model analysis, interpretation, hypotheses testing and discussion.

  CHAPTER 5: CONCLUSION AND SUGGESTION This last chapter contains the summary of research conclusion including the research limitation and suggestion for the next research.

  CHAPTER 2 LITERATURE REVIEW

2.1. Theoretical Review

  Agency theory is the grand theory that elucidates the conflicts potentially to be happened among manager, stockholder, and bondholder, which can influence the financial structure of the company. Moreover, the investment opportunity set (IOS) comes up as supporting theory that explains the investment opportunities within certain conditions in company regarding its influence towards debt structure and agency conflict of the company.

2.1.1. Agency Theory

  This research examines the influence of investment opportunity towards leverage, debt maturity and protective covenants. This theory explores the divergence of opportunistic behavior among manager, stockholder, and bondholder, which potentially raise the agency conflict and potentially influence the debt structure of the company.

  According to Jensen and Meckling (1976), agency relationship is a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision-making authority to the agent. If both parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.

  10 Jensen and Meckling (1976) argue that the divergences of interest between principal and agent can be reduced, when principal is establishing appropriate incentives for the agent and by incurring monitoring costs, which are designed to reduce deviation activities of the agent that may be able harm the principal.

  In agency relationship, the principal and the agent will incur positive monitoring and bonding costs. Jensen and Meckling (1976) define agency costs in general as the sum of:

  1. The Monitoring Expenditures by the Principal, Monitoring cost is such as cost for writing provisions, costs to restrict deviation activities of the agent.

  2. The Bonding Expenditures by the Agent, Bonding cost is the cost incurred to pay the agent to expend resources to guarantee that the principal will be compensated if the agent does take such actions. The example is bondholder paying manager to agree incurring the cost of providing financial reports and to have their accuracy testified by an independent outside auditor.

  3. The Residual Loss.

  The dollar equivalent of the reduction in welfare experienced by the principal because of this divergence and the covenants that restrict management’s ability to take optimal actions on certain issues is also a cost of the agency relationship.

  The agency conflict might be happened among stockholder, manager and bondholder. The larger the divergence of opportunistic behavior is the greater the appearance of agency conflict. Those agency relationships will be explored in detail.

2.1.1.1. Agency Theory of Outside Equity

  Separation of ownership and control are closely associated with the general problem of agency between stockholder and manager. This subchapter explores of why and how the agency costs of outside equity are generated by the corporate.

  Jensen and Meckling (1976) observe that when an owner-manager owns 100 percent of residual claims, there will be no separation between corporate ownership and control. This means that the owner-manager bears all the cost and generates all the pecuniary returns and non-pecuniary returns of his actions such as, the attractiveness of the office staff, the level of employee discipline, the kind and amount of charitable contributions, personal relations with employees.

  If the owner-manager sells the part of his equity claims on the corporation to stockholders, then agency costs will be appeared by the divergence between his interest and those stockholders. This due to the owner-manager also has worked to bear the entire wealth effects in accordance increasing firm value while the owner-manager’s fraction of the equity falls and induces his fractional claim on the outcomes falls too. Thus, this will encourage him to appropriate larger amounts of the corporate resources in the form of perquisites consumption.

  Singhania and Seth (2010) elucidate that owner-manager is expected to act as taking decisions on behalf of prospective stockholders. In actuality, managers may simply be interested in achieving their own targets, which may largely differ from the overall organizational goal of maximization of company value, such as higher bonuses, job position safety and security, etc. Managers because of formal powers may try to lever decisions to meet their own goals, which may potentially meet with disapproval from stockholders. In this way, owner or stockholders may succeed in discouraging the relatively selfish motives of managers. Moreover, shareholder and manager try to achieve a balance for these divergent goals to not hinder the daily operational of the company. However, this entire process involves considerable monitoring and control and thereby results in this so called agency costs.

  Explicitly, agency cost against malfeasance on the part of the manager, and contractual limitations on the manager’s decision-making power, which impose costs on the firm because stockholder limit manager’s ability to take full advantage of some profitable opportunities as well as limiting manager’s ability to harm the stockholders while making himself better off. In practice, it is usually by expending resources to alter the opportunity the owner-manager has for capturing benefits. These methods include auditing, formal control systems, budget restrictions, the establishment of incentive compensation systems, which serve to identify the manager’s interests more closely with those of the outside equity holders, and so forth. In order to carry out their functions properly, management should be given incentives and adequate supervision. Control can be done through ways such as binding agents, examination of financial statements, and restrictions on management decisions can be taken.

  Generally, when the agency costs are engendered by the existence of outside owners are positive, the company will pay the outside owners to sell back their equity claims to an owner-manager who can avoid these costs. Other ways, debt and less external equities can reduce the agency cost of outside equity.

  Jensen and Meckling (1976) stated that the usage of debt aims to overcome the agency cost of outside equity. Regarding this argument, the interests of managers and stockholders are likely to diverge in industries that generate abundant free cash flow. Managers supposedly have a stronger preference for retaining free cash flow within the firm, while stockholders have a stronger preference for using free cash flow for financing higher payouts in the form of dividends and share repurchases. Debt is one means of resolving this tension. It can be understood from two perspectives. First, using debt means a firm can sell less external equity and still finance its operations. If agency cost of outside equity rise more than proportionally, then minimizing outside equity sales will reduce the deadweight agency cost. Second, the benefit of using debt is that it reduces managerial perquisite consumption. The need to make regular debt-service payments effectively disciplines managers.

2.1.1.2.Agency Theory of Debt

  This theory recognizes when a firm has debt that potentially increase the conflict interest between stockholders and bondholders. The conflict arises because of the different mechanism of revenue receipt between stockholders and bondholders. Bondholders earn a fixed income of interest and repayment of principal, while stockholders earn residual income from corporate profits that are used to meet obligations to bondholders. This causes the incentives of corporate managers to act in the interests of stockholders. However, those conditions show that debt arise the conflict between shareholder and bondholder. According to Megginson et al. (2007: 491) and Ross et al. (2008: 464), these actions include but are not limited to:

  1. Unauthorized asset disposition – Stockholder may attempt to transfer corporate assets to themselves by liquidating the firm’s assets and distributing the proceeds as a dividend or repurchasing shares at a premium.

  2. Claim dilution – Stockholder may attempt to dilute the claim of existing bondholder by issuing debt of higher priority than existing debt.

  3. Asset substitution – Acceptance of substituting a riskier asset promising a higher return than that had been anticipated by bondholders when bondholders were purchasing their bonds. In principle, bondholders involve of various covenants in the indenture provisions, to limit the managerial behavior. The covenants impose voluntary constraints on management’s activities that prevent corporate managers from taking certain actions and require them to take others. At the same time, these covenants provide bondholders assurance that the firm’s management will not expropriate their wealth. Consequently, bondholders would be willing to pay more for a debt contract that includes protective covenants. All costs associated with such covenants are monitoring costs. Moreover, bondholder would pay manager to agree in incurrence the cost of providing financial reports and to have their accuracy testified to by an independent outside auditor. This is an example of bonding costs.

2.1.2. Investment Opportunity Set (IOS) Theory Investment opportunity set plays an important role in financing corporate.

  The mix of assets in place and investment opportunities influence a firm’s capital structure, the maturity and covenant structure of its debt contracts (Billett et al., 2007). IOS theory enhances the decision in which the investments in place have been financed, whether with debt or with equity, and if debt, whether with short or long-term debts, which influences the profits stockholders make from exercising growth options.

  Myers (1977) states that the essence of growth for a company is generating profit from investment opportunities, in accordance increasing the firm’s value.

  The greater the profitable investment opportunity, the investment will increase. Regarding IOS theory, the company is a combination of assets in place that it is tangible and investment opportunities that intangible. The combination of both assets in place and investment opportunities will affect the capital structure and firm value.

  Regarding to Jensen (1986) companies with high investment opportunities have high growth rates, active conducting investment, have low cash flow and smaller assets in place. In these circumstances, firms potentially suffer underinvestment problem. In addition, Myers (1977) explains that the underinvestment problem occurs when firms with high investment opportunities facing opportunities to invest in positive NPV projects that also require the higher usage of funds. In the low free cash flow condition, the company will take on debt to take investment opportunities that exist. However, it is susceptible in appearing conflict between stockholders and bondholders. Stockholders insist that profits should be distributed as dividend. While bondholders assume that profits should be used to pay off debt. In such circumstances, the company will choose to leave the project with a positive NPV and lost investment opportunities. If the company wants to continue the positive NPV projects, companies with high investment opportunities have some alternatives such as using internal funds, using a small amount of debt with shorter debt maturity, or involving protective covenants.

  Moreover, according to Myers (1977), companies with lower investment opportunity have a low growth level, and have large free cash flow and asset in place. In these circumstances, the company is potential to overinvestment problem. Overinvestment problem is caused by the excess capital, which will lead to conflict due to the divergence perspectives between the managers and stockholders. Managers argue that the excess in capital shall be used to invest in project and currently they tend to invest the capital excess on the risky projects. Managers consider that this action would raise the investment opportunity above the optimal level. Otherwise, stockholders insist to distribute the capital excess as dividends.

  By using debt this problem can be solved, the managers can carry out a new project, while managers able to provide assurance to stockholders that existing excess capital will divide as dividends. In addition, debt collection will put the company on the part of external oversight, thereby reducing tendency of managers to invest in projects that are not profitable. Hereby, company will be more effective to deal with debt when the company has low investment opportunity (Jensen, 1986).

2.1.3. Variables in this Research

2.1.3.1. Leverage

  Applying leverage means using borrowed money to earn a return greater than the cost of borrowing (Megginson et al., 2008: 655). Leverage is commonly described as the use of borrowed money to make an investment and return on that investment (Bhatti et al., 2010). Thus, leverage can be defined as the proportion usage of debt, which will be used as financing sources for which predicted as profitable projects, then it is expected to increase the value of the company by reflecting incremental in its actual earnings.