Advances in Economics, Business and Management Research, volume 89 1st Asia Pacific Business and Economics Conference (APBEC 2018) Analysis of Correlation Between Internal Financing and External Financing (Empirical Study on Manufacturing Companies Listed on Indonesia Stock Exchange during 2010–2015) Hanny Goenawan Gede H. Wasistha Department of Accounting Department of Accounting Faculty of Economics and Business Faculty of Economics and Business Universitas Indonesia Universitas Indonesia Depok, Indonesia Depok, Indonesia [email protected] [email protected] Abstract—The purpose of this study is to obtain empirical first proposition states that in a world without taxes and evidence about the negative relationship between internal and without bankruptcy costs, the value of a firm with debt equals external funding for manufacturing businesses. The study uses the value of the firm without debt. In other words, the choice multiple linear regression with panel data for manufacturing of capital structure has no effect on the value of the firm. The companies listed on the Indonesia Stock Exchange from 2010 to second proposition states that in the presence of taxes, the 2015. The study shows there is a negative relationship between value of the firm will increase with the use of debt in the internal and external funding for both constrained and capital structure [5]. The implication of the first proposition is unconstrained firms. The result of this study is consistent with that a company can choose to have as much debt as possible “pecking order” theory. without affecting corporate value. This is only true under the Keywords—Constrained firms; external funds; internal funds; conditions of the MM theory. In reality, companies that have pecking order theory; unconstrained firms. debt in the capital structure should consider the risk of bankruptcy (financial distress). The second proposition of this I. INTRODUCTION theory suggests that in the presence of taxes, the funding structure does affect firm value. A debt-funded company will In today’s economic climate, companies must strive to have a larger value than a non-debt funded company because achieve a competitive advantage to succeed in the business using debt reduces corporate income taxes, since interest world. Companies can obtain competitive advantages such as expense is deducted from income before taxes. However, in advanced technology, high quality products, and superior practice the MM theory has been criticized because the human resources through both internal and external funding. assumptions in the theory do not allow for the existence of Internal funding is obtained through retained earnings, while transactions costs, bankruptcy costs, agency costs, and external funding can be obtained through a combination of asymmetric information. debt and equity [1]. Bank Indonesia revealed that the growth rate of corporate debt in Indonesia has increased each year. In The pecking order theory proposed by Myers suggests that the Rupiah and Foreign Exchange Loan Position Reports a firm’s tendency to use internal funding sources rather than provided by Commercial Banks and Rural Banks by the Group external funds is linked to the information asymmetry between of Banks and Establishments, the loan rate in 2015 increased company owners (investors) and management [6]. by 10.5% compared to 2014. The average increase in total Information asymmetry makes external funding more foreign currency and corporate debt positions from 2011 to expensive. In addition, there is also a trade-off theory that 2016 was 17% [2]. Companies generally require external states the value of firms can be increased using tax advantages financing as an option to finance short-term operational needs derived from debt holdings. Company managers are assumed and long-term investments. to maintain an optimal debt / equity ratio to minimize costs associated with market imperfections, and to maximize the Financial flexibility is the main goal of any corporate trade-off between the tax advantage provided by using debt, financial policy in the United States and Europe [3]. Financial and financial distress costs caused by a level of debt that is too policy must be able to ensure sufficient funds are available for high [7]. In providing funding for investment and operational both near-term and long-term investment needs, especially activities, the company strives to ensure the availability of when the company faces financial constraints. The selection funds as they are needed. Companies that have frictions in of a funding structure becomes one of important strategy terms of funding tend to use internal funds before turning to decisions for a company. The funding structure determines external funds. This happens because external funds (both debt both short-term and long-term funding sources. Company and equity) have higher costs and risks than internally management is responsible for determining the proportion of generated funds. In certain circumstances, internal and each within the funding structure to create an optimal funding external funding sources are substituted. The company is said structure in terms of flexibility as well as cost of capital [4]. to be experiencing financial constraints when the number of Capital structure theory begins with the Modigliani-Miller internal fund sources gives a significant effect in corporate (MM) theory (1958) which consists of two propositions. The financing [8]. Copyright © 2019, the Authors. Published by Atlantis Press. This is an open access article under the CC BY-NC license (http://creativecommons.org/licenses/by-nc/4.0/). 21 Almeida and Campello shows a negative relationship the tax advantage of interest versus dividends. When the between internal financing (profitability) and external corporate income tax component is included, the firm's value financing (debt) [9]. The results of this study supports the with debt is equal to the value of the firm without debt plus the pecking order theory. The negative relationship between debt tax shield [5]. internal funding and external financing is more visible in companies that do not experience financial constraints, for The pecking order theory developed by Myers and Majluf example: firms that pay big dividends, have large fixed assets, suggests that firms tend to choose internal funding over and have a high quality rating on their public debt issues. In external funding [15]. The same concept is expressed by Frank the same study, Almeida and Campello found a and Goyal who state there are three sources of funding for a complementary relationship between internal and external company: retained earnings, debt and equity [16]. Retained funding in financially constrained firms [9]. earnings have no risk of loss, debt has a low risk of loss, while equity has a high risk of loss. In the view of investors, equity Prameswara’s research on banking and mining industry is clearly riskier than debt, which prompts investors to expect firms listed on the Indonesia Stock Exchange shows that higher returns when investing in equity (stocks). For a companies with and without financial constraints have company with retained earnings sufficient to finance a behavior consistent with the pecking order theory [1]. The company's business, the company does not need to access study shows that highly profitable firms tend to reduce their external funding. If the company does not have sufficient level of debt. These results are supported by research retained earnings, the company is likely to choose debt before conducted by Sugiyanto, component companies and issuing new equity to satisfy its external funding needs. automotive companies listed on the Indonesia Stock Exchange Cahyadi reveals the condition of information asymmetry and use internal funds first as a source of funding, only using signaling problems as factors that lead to this theory being external funding if internal funds are insufficient [10]. accepted as the modern capital markets point of view [17]. However, Dianti shows that property companies listed on the Indonesia Stock Exchange refer to the trade-off theory in Frank and Goyal argue that this trade-off theory arose from determining the capital structure of a company because it the debate over the capital structure irrelevance theory considers the tax benefit of using debt [11]. advanced by Modigliani-Miller I [14]. The trade-off theory states the optimal debt ratio is determined based on the balance Therefore, the existing research on this topic in Indonesia between the profit and loss from taking on debt. According to has produced inconsistent results. This presents an opportunity Myers a company is said to embrace the trade-off theory in for further research. This study focuses on the relationship determining its funding structure when management regulates between internal and external funding on companies that fall the value of the firm's debt and moves toward a debt-to-equity within the constrained and unconstrained categories as defined ratio “target” [6]. The target to be achieved by companies that by Almeida and Campello [9]. This research aims to determine hold this view is a balance between the tax shield provided by the correlation between internal and external funding for debt versus the bankruptcy costs associated with debt. Ross, companies without financial constraints and the correlation et.al show that a funding structure based on the trade-off between internal and external financing for companies that theory would allow the management of the firm to calculate operate with financial constraints. the balance between gains from the debt tax shield and the cost of debt, i.e., the cost of financial distress [5]. To achieve an II. LITERATURE REVIEW optimal funding structure, debt costs should not exceed the tax The capital structure of an enterprise consists of equity benefits of the debt. financing and debt financing. Determining the proportion of One factor that affects a company's funding decisions is each type of funding is a decision made by the company's the difficulties and obstacles that companies experience when management. The goal is to maximize corporate value [12].