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Middle Eastern Finance and Economics

ISSN: 1450-2889 Issue 9 (2011)


EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/MEFE.htm

The Effect of Mispricing on Investment of Indonesian Firms:


Do Financial Constraints Matter?
Irwan Trinugroho
Faculty of Economics, Sebelas Maret University, Indonesia
E-mail: irwan@fe.uns.ac.id or irwan_feuns@yahoo.co.id
Risal Rinofah
Master of Science in Management, Gadjah Mada University, Indonesia
E-mail: izal_7@yahoo.com
Abstract
The objective of this research is to examine the effect of mispricing on firms
investment behavior and capital structure. We also test the role of the level of financial
constraints in the relationship between mispricing and investment. Using pooled panel data
of Indonesian manufacturing firms from 2003-2007, we find that mispricing has positif
impact to firms investment. However, this effect only slightly different whether on high
financial constraint firms (financially constraint) or on low financial constraint firms (less
constraint). Moreover, this research also find that mispricing influence firms in choosing
sources of funding which can be seen on their debt to equity ratio (D/E). To check the
accuracy of this examination, we employ some robustness test and use several control
variables. These results are consistent with and can be explained using market timing and
catering hypotesis.

Keywords: Mispricing, Investment, Capital Structure, Financial Constraints

1. Introduction
Capital market plays important role for firms, Wang et al. (2008) explain that one of the important
functions of capital market is as a medium to obtain source of funding. When the market condition is
efficient, value of stock will fully reflect the fundamental of firm. But, in fact, stock price movement is
not entirely a reflection of its fundamental value because the existence of non-fundamental factors such
as market sentiment, behavioral biases of investors (Lakonishok et al., 1994), systematic errors when
assessing stock (Stein, 1996), asymmetric information (Tobin, 1969) causing the value of stock deviate
from its fundamental value (misprice).
This condition influences firms investment decisions. Managers can take advantage of the
overvalued stock as a source of investment funding because the cost of capital becomes cheaper.
Conversely, managers avoid selling stocks at undervalued because the cost of capital is higher. For
high financial constraint firms, their source of funding is concentrated on stock, this condition affect
investment decision. Instead, for low financial constraint firms, the value of stock does not affect their
investment decisions because of the availability of adequate funding sources. The sensitivity difference
is known as the equity financing channel (Stein, 1996).
The examination of the relationship between investment, mispricing and financial constraints in
various combinations have been done especially in developed countries (eg, Polk and Sapienza, 2002;

Middle Eastern Finance and Economics - Issue 9 (2011)

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Baker et al., 2003; Chang et al., 2007). Polk and Sapienza (2004) find that overvalued (undervalued)
firms tend to overinvest (underinvest). Overvalued firms tend to accept project with negative net
present value (NPV), consequences of excess sources of funding. While, the undervalued firms tend to
reject project that has positive NPV because of the limitation of funding. Baker et al. (2003) conducted
research in the US using 52,101 observations, they find that stock price movements in the capital
market are able to influence investment more strongly to firms with high financial constraint than low
financial constraint firms.
Wang et al. (2008) explain that differences in social system, the structure of microeconomics,
economic development stage and the structure of financial markets in different countries lead to
differences in the relationship between stock market and investment. This is evidenced by their
research in China found that the policy of investment was not significantly response the movement in
capital market. Therefore, we try to examine the relationship between stock market and firms
investment in Indonesia, a developing countries with rapid growth in capital market. We expect that
our results give a broader understanding of the relationship between stock market, investment, capital
structure and the role of financial constraint in the context of Indonesian firms.

2. Previous Research
2.1. Mispricing and Investment
Mispricing is defined as a condition in which the value of stock in the capital market different from its
fundamental value. Some causes of the mispricing are the presence of asymmetric information between
manager and investor, as well as the bias of investor assessment (Alzahrani, 2006). Bias in assessment
is an element of investors irrationality when making an assessment of a stock. Sadka and Scherbina
(2007) find that the mispricing also arise due to disagreements among the analysts associated with
transaction costs or the liquidity of the stock. The relationship between stock prices and firms
investment have a lot of attention since the recognizing that the two variables have a very close
relationship. This is based on two theoretical explanations which states that: first, the stock prices
reflect information about the firms fundamental factors and therefore the fundamental condition of the
firm is a factor affecting investment decision. Second, the firm may be experiencing financial
constraint, which may hamper the firm to achieve an optimal investment plan so that the increase in the
stock price is expected to be a cheaper source of funding to be used as a targeted investment fund
(Chen et al., 2005).
2.1.1. Market-Timing Hypothesis
A manager will take advantage of mispricing by issuing overvalued stocks to enjoy lower capital costs
and otherwise, avoid issuing undervalued stocks to avoid high capital costs. The existence of this
opportunity encourages managers to implement investment plans. Instead, managers of undervalued
firms avoid to issuing stock, even if they need it, because of the high cost of capital in undervalued
stocks. In other word, overpricing tends to make increasing investment opportunity and vice versa,
underpricing tends to reduce the investment opportunities.
2.1.2. Catering Hypothesis
Managers attempt to please the wishes of the investors because they want to maintain their "reputation"
(Holmstrom, 1999), and maximize their compensation based on stock price. As a result, when the
firm's stock is overvalued, managers will try to increase investment to encourage the further
overvaluation. While, managers in firms with undervalued stock tend to reduce the investment to avoid
the further undervaluation.

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2.2. The Effect of Financial Constraints on the Relationship between Mispricing and Investment
The term financial constraints which was introduced by Fazzari et al. (1988) basically have the same
term with equity dependency (Stein, 1996, Dong et al., 2007), both of them describe the condition of
the firm facing difficulties to seek sources of funding. High financial constraint firm is characterized by
inadequacy of internal funds (eg, cash and retained earnings) and the difficulty in obtaining external
capital in the form of debt. This situation makes the firm rely on selling of stocks to fund its
investments (Baker et al, 2003). Stein (1996) and Dong et al. (2007) define this condition in terms of
equity-dependent. Conversely, firms that do not experiencing this problem are called as low financial
constraints or non-equity dependent. Kaplan and Zingales (1997) explain that funding constraints could
result from differences in capital costs from internal resources and external resources. For firms with
low financial constraints, they do not rely on stock, so the condition of mispricing (overvalued or
undervalued) will not affect their investment decisions. In contrast, investment decisions of high
financing constraint firms may be more sensitive to the value of its stock. From this theory, it can be
concluded that the level of funding constraints may affect the sensitivity of the effect of mispricing on
investment.
2.3. Mispricing and Capital Structure
Research conducted by Hovakimian et al. (2001) find that the tendency to sell stocks when the
condition is overvalued can be used to pay off some debt to achieve the desired leverage condition.
Firms selling stock when the stock is overvalued making the debt-equity ratio become lower. Instead,
if the firms will not sell stock when the condition is undervalued and choose another funding source
that is cheaper or with other considerations (for example, prefer debt) will make the debt-equity ratio
becomes higher. At the same time, the increasing of equity due to overvalued condition can also be
accompanied by a significant deterioration in debt.

3. Hypotheses
Based on the theory and previous research, we develop the following hypotheses:
H1: Mispricing positively affect investment
H2: The sensitivity of the effect of mispricing on investment in firms with high financial
constraints is greater than firms with low financing constraints
H3: The higher (positive) level of mispricing, the lower the debt-equity ratio, the lower
(negative) level of mispricing, the higher the debt-equity ratio.

4. Research Method
This study use the data from 2003-2007, financial report data obtained from the OSIRIS database and
market data obtained from Indonesia Stock Exchange (IDX). Samples are all manufacturing firms
listed in IDX, consist of 142 firms (Indonesian Capital Market Directory, 2007).
4.1. Variables
4.1.1. Proxy of Mispricing
In several previous studies (Dong et al, 2006; Bloomfield and Michaely, 2004; Bartov and Kim, 2004;
Baker and Wugler, 2002), mispricing proxy that be used is the actual value of market-to-book. This is
different from the methods used by Rhodes et al. (2004) that break down the market-to-book into two
components, mispricing component and growth opportunities components. The concept was applied in
the case of the stock merger that are different from the context of this research. In our study, mispricing
will be measured by comparing the predicted value of market-to-book (M/BPre) with the actual value
of market-to-book (M/BAct). The argument is that the actual value of market-to-book should have

Middle Eastern Finance and Economics - Issue 9 (2011)

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reflected the company's fundamental factors, but due to the non-fundamental factors, it is possible that
the actual value is not as it should be. Therefore, the difference between the predicted value and actual
market-to-book can be used as an indicator of mispricing. Model prediction of market-to-book value is
formed based on fundamental factors. We use several fundamental factors that are Earning Per Share
(EPS), Price Earning Ratio (PER), Return on Equity (ROE), Return on Assets (ROA), Dividend Payout
Ratio (DPR), Price to Sales (PTS), Price to Free Cash Flow (PTFCF).
M/BPr
e

= 0 + 1 EPSt 1 + 2 PERt 1 + 3 ROEt 1 + 4 ROAt 1 + 5 DPRt 1 + 6 PSt 1 + 7 PFCFt 1 +


(Model 1)
EPS = Earning Per Share (Net income/shares outstanding)
PER = Price Earning Ratio (Market stock price/EPS)
ROE = Return on Equity (Net income/equity)
ROA = Return on Asset (Net income/total asset)
DPR = Dividend Payout Ratio (1-Plowback ratio)
PS
= Price to Sales (Market stock price/(sales/shares))
PFCF = Price to Free Cashflow (Market stock price/(Free Cash Flow/shares outstanding))
While the actual value of market-to-book will be calculated by following formula:
Market value of share
M/B Act =
Book value of share
Thus, mispricing will be measured by the formula:
Mispricing (MIS) = (M/BAkt) - (M/BPre)

4.1.2. Sample Clasification based on Financial Constraints


Sample classification based on financial constraints refers to Kaaro (2004), Kaplan and Zingales
(1997) and Cleary (1999). The steps are as follows:
a. Grouping initial sample based on the payment of dividends. Firms that pay dividends included
in the category of low financial constraints (LFC), while firms that do not pay a dividend
included in the category of high financial constraints (HFC). LFC group will be given the score
1 and score 0 for HFC.
b. Establishing logit model to predict financial constraints based on financial variables.
P
(Model 2)
FCi = Ln i = 0 + 1CR + 2 PROFIT + 3 CP + 4 SLACK + 5 RE + i ,t
1 Pi
Z = 0 + 1 FC i ,t
Pi =

1
eZ
=
1 + e Z 1 + e Z

= Financial Constraints
= Current Asset/Current Liability
= Operation Profit/Total Asset
= Positive change: 1, Negative change: 0
= [Cash+ Short Term Investment + Inventory + Receivables Short
Term Debt]/Asset
RE (Retained Earnings) = Retained Earnings/Aset
Pi
= Probability
e
= Exponential Value
c. When the probability Pi is greater than the probability cut-off (P> Pc) the firm into the category
of LFC (1), if Pi <Pc, the firm into category of HFC (0). Determination of cut-off value is based
on observation of actual dividend policy.
FC
CR (Current Ratio)
PROFIT
CP (Change of Profit)
SLACK

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Middle Eastern Finance and Economics - Issue 9 (2011)

4.1.3. Investment
Investment expenditure (INV) of firms will be calculated using the following formula (Kaaro, 2004):
Investment CashFlow t
INV t =
NetFixedAs sets t 1
Investment cash flow is used to measure the net capital expenditure. The value of net fixed
assets use the net asset value at the beginning of the period, while the value of the investment use the
value at end of period (Vogt, 1994; Kaplan and Zingales, 1997; Cleary, 1999).
4.1.4. Capital Structure
The proxy of capital structure employs the ratio of debt to equity (D / E) which will be calculated using
the formula:
Total Debt
D/E Ratio =
Total Equity
4.1.5. Control Variables
Besides the main variables, this research employs some control variables that are Leverage (debt/total
asset), Cash Flow (cash flow/total asset), Cash (cash and equivalent cash/total asset), Sales (net
sales/total asset), Year (age of the firms), TAR (Tangible to Asset Ratio) and Size (In total asset).
4.2. Hypotheses Testing
Then, to test the hypotheses, we use following models:

Model to Test the H1

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

(Model 3)

Investmenti,t = 0 + 1MISi,t 1 + 2Cashflowi,t + 3 Yeari,t + 4 Levi,t 1 + 5Cashi,t 1


+ 6 Salesi,t +
i,t

(Model 4)

Model to Test the H2


Investment i,t = 0 + 1 MIS i,t 1 + 2 KPI,T + 3 MIS * FC i,t + 4 Cashflow i,t + 5 Year + i,t (Model 5)
t

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


t

(Model 6)

+ 7 Cashi,t 1 + 8 Sales + i,t

Model to Test the H3


D / E t = 0 + 1 MIS

i ,t

+ M / B i , t + TAR

i ,t

+ Size

i ,t

+ i ,t

(Model 7)

5. The Result of Hypotheses Testing


5.1. Prediction Model of Market-to-Book Value
Regression of prediction model shows the value of coefficient of determination is quite high which
reached 62.8% (see table 1), but there is one variables that is not significant (DPR), then excluded from
the prediction model.

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Middle Eastern Finance and Economics - Issue 9 (2011)


Table 1:

Regression of Prediction Model of Market to Book Value

Variabels
Coefficient
t value
EPS
0
1.503
PER
0.005
2.147**
ROE
0.005
3.798***
ROA
0.01
2.941***
DPR
0.122
0.597
PTS
0.133
2.350**
PTFCF
0.11
21.665***
Note: ***: Significant at 1%, **: Significant at 5%, *: Significant at 10%

Constant

Adjusted R square

0.206

28

Based on the regression results, the prediction model of market-to-book value is as follows:
M/Bpre = 0,206 + 0,005PER + 0,005ROE + 0,010ROA + 0,133PTS + 0,110PTFCF
Then, reduction of the actual value to the prediction model find that 311 observations (62.8%)
are overvalued stock and 184 observations (37.2%) are undervalued.

5.2. The Result of Testing H1


Table 2:

Test of the Effect of Mispricing on Investment

Independent
Coeficient
Variables
Constant
0.210
Mispricing
0.021
Investment (INV)
Main Model
Cashflow
0.132
Year
0.003
Constant
0.544
Mispricing
0.010
Cashflow
0.348
0.002
Investment (INV) Year
Robustness test
Leverage
-0.406
Cash
0.450
Sales
-0.304
Note: ***: Significant at 1%, **: Significant at 5%, *: Significant at 10%
Model

Dependent
Variables

t value
6.634***
3.095***
2.254**
3.166***
10.777***
1.758*
6.285***
2.253**
-10.929***
2.708***
-4.426***

Adjusted R
square
0.056

0.341

The results of testing H1 show that mispricing occurred in the firms stock price has positive
effect on the level of investment. The results in accordance with previous studies (eg Chang et al,
2005; Chang et al, 2007; Xiao, 2003; Baker et al, 2003; Alzahrani, 2006; Polk and Sapienza, 2004).
This result indicates that the value of the stock market in Indonesia provide information for managers
relating to the firms investment decisions. This result are also consistent and can be explained by two
theories, market timing and catering hypothesis. High stock price can be considered by managers as a
sign that investors have positive perception to the firm's investment decision. This result also indicate
that overpriced stocks tend to increase the firm's investment opportunities. Robustness test show
consistency that mispricing affects investment levels but the significance level is decreased. These
three variables, Leverage, Cash and Sales show significant effect on investment and consistent with the
results of previous research.

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5.3. The Result of Testing H2


Table 3:

Logit Regression to Predict Financial Constraints

Variabels
Coefficient
Wald statistik
Constant
-1.426
40.436***
CR
-0.064
1.564
PROFIT
3.666
11.562***
CP
-0.133
0.416
RE
1.526
24.389***
SLACK
1.084
3.834**
Note: ***: Significant at 1%, **: Significant at 5%, *: Significant 10%

Nagelkerke R square

0.234

Based on logit regression model there are two variables that are not significant (CR and CP),
then excluded from the prediction model. The predicted model of financial constraints are:
P
FC i = Ln i = 1,426 + 3,666 PROFIT + 1,084 SLACK + 1,526 RE
1 Pi
To ensure that the model has the ability to predict precisely, We use cross classification
between actual and predicted observation. This method indicates that the prediction model has
predictive ability of 73.3 percent.
Table 4:

Test of the Effect of Mispricing on Investment Based on Financial Constraints

Independent
Coeficient
Variables
Constant
0.119
Mispricing
0.036
Cashflow
0.143
Investment (INV)
Main Model
Year
0.001
FC
0.257
FC*MIS
-0.029
Constant
0.494
Mispricing
0.031
Cashflow
0.124
Year
0.001
Investment (INV) Leverage
-0.328
Robustness test
Cash
0.164
Sales
-0.327
FC
0.125
FC*MIS
-0.022
Note: ***: Significant at 1%, **: Significant at 5%, *: Significant at 10%
Model

Dependent
Variables

t value
4.421***
3.462***
1.759*
1.120
9.272***
-1.902*
10.178***
3.355***
1.696*
1.335
-8.174***
1.242
-5.868***
4.535***
-1.630

Adjusted R
square

0.23

0.389

The results of testing H2 indicate that the degree of financial constraint only slightly affect the
degree of the effect of mispricing on investment (see t value of FC*MIS in table 4). These findings
somewhat different with the theory and previous research results (Stein, 1996; Baker et al., 2003;
Shleifer and Vishny, 2003; Chang et al., 2005; Chang et al., 2007). The low difference based on
financial constraint shows that whatever the level of their financial constraints, the two groups of firms
will react nearly equal to the changes in market prices. The similar response in both LFC and HFC can
be explained by the theory of Catering hypothesis which states that one reason why managers respond
to the stock market because the stock can affect the "reputation" and their compensation.

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5.4. The Result of Testing H3


Table 5:

Test of the effect of mispricing on capital structure

Independent
Coeficient
Variables
Constant
-4.306
M/B
0.057
Without Dummy
D/E
Size
0.270
TAR
0.118
MISPRICING
-0.066
Constant
-4.622
M/B
0.057
With Dummy
Size
0.319
(FC ; LFC: 1,
D/E
TAR
-0.498
HFC: 0)
MISPRICING
-0.066
FC
-0.578
Note: ***: Significant at 1%, **: Significant at 5%, *: Significant at 10%
Model

Dependent
Variables

t value
-3.950***
2.478**
4.948***
0.301
-2.512**
-4.267***
2.499**
5.683***
-1.149
-2.529**
-3.197***

Adjusted R
square

0.071

0.09

The results of testing H3 show that mispricing significantly decrease the leverage level
reflected by debt to equity ratio (see table 5). This is consistent with the theory (Tobin, 1969;
Furstenberg, 1977; Chirinko and Schaller, 2007) and previous research (Hovakimian et, al., 2001).
According to Hovakimian et al. (2001), in addition to the reasons for investment financing, the
condition can also be used by overvalued firms to achieve the desired leverage in a way pay off some
debts with the proceeds from the sale of stocks. Conversely, if stocks are undervalued, it will make
managers refrain from selling stock due to the relative cost of capital becomes greater.

6. Summary and Concluding Remarks


Using different proxy from previous mispricing studies, our study finds that (1) The changes in the
market value of stock positively affect the level of investment. High stock price increase the firm's
investment opportunities, then increase the likelihood of a firm to increase its investment. Conversely,
the low stock price tend to reduce investment. But (2), this effect is only slightly different based on the
level of firms financial constraint. Every manager will react nearly equal to changes in market prices
of their stocks. (3) Mispricing negatively affect the firm's capital structure, although with a relatively
small portion. In addition, we suggest for further research to modify the financial constraint
classification because we point out limitation of our study that the classification of financial constraints
based on dividend policy can still be debated because sometimes firms do not pay dividends more
appropriately reflect the financial distress rather than financial constraints.

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Middle Eastern Finance and Economics - Issue 9 (2011)

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