International Journal of Innovation, Creativity and Change. [Link].

net
Volume 6, Issue 8, 2019

Capital Structure Determinants of

Shariah and Non-Shariah Companies
at Bursa Malaysia – Dynamic
Approach
Rehan R.a, Abdul Hadi A.R.b*, a,bUniversiti Kuala Lumpur Business School,
Malaysia
*Corresponding Author: b*abdrazak@[Link]

This is a comparative study that examines capital structure

determinates involving public listed Shariah and non-Shariah
companies, in Bursa Malaysia from 2005 to 2016. There are six capital
structure determinants identified in this study, namely total assets,
fixed assets, current assets, sales, return on equity and earning per
share. Deploying a dynamic estimation model via Generalized
Method of Moments (GMM) upon these six capital structure
determinants, the study reveals that current asset is the only significant
capital structure determinant for the shariah-compliant category. With
respect to the non-Shariah companies, total assets and fixed assets are
the two significant determinants. It is worthy to note that the lag
dependent Debt-Equity is also significant for both Shariah and non-
Shariah categories. The significant role of this lag dependent variable
suggests the importance of dynamic capital structure in explaining
variations in capital structure of public listed companies in Malaysia.
Similarly, the significant functions of current assets and fixed assets
directly implies the relevance of Trade-Off theory in explaining a
firm’s choice of capital structure. In terms of profitability and value of
total assets, the non-Shariah companies are performing better than
their counterparts. However, it is important to note that this study is
subject to survivorship bias as those loss-making companies have been
entirely excluded from the analysis.

Key words: Capital Structure Theories, Shariah Companies, Non-Shariah

Companies, Trade-Off Theory, Dynamic Panel Data Model, Bursa Malaysia.

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Introduction

The topic of capital structure has attracted attention of many scholars and practitioners, and it
is the most debated topic not only in academia but also in the corporate world (Demirgüneş,
2017). Capital structure describes the distribution of equity and debt in financing business
operations and managing the capital structure efficiently will enable companies to emerge
stronger over time (Foo et al., 2015; Saad, 2010). For this reason, a financial manager must
strive to put a company at the optimal capital structure level (the best mix of debt and equity)
that maximizes the firm’s value (Mazhar et al., 2010). Managing a company at the point of
optimal capital structure is desirable because it will benefit the company in achieving its
long-term growth goals (Razak et al., 2017). However, one must admit that the task of
attaining this optimal point is rather challenging for every financial manager. Despite the fact
that there is a myriad of studies conducted on determinants of capital structure upon non-
Shariah companies in both developed and developing markets, little attention has been given
on Shariah-compliant firms (Ahmad and Azhar, 2015).

At present, the Shariah-based financial model is one of the celebrated topics among
economists and researchers. Fundamentally, conventional finance is hinged upon a debt-
based financial instrument that promotes a risk transfer. In contrast, Islamic finance is
attached to an asset-based framework that focuses on risk sharing (Hasan and Dridi, 2010).
Also, Islamic finance prefers equity-based financing over debt financing (Hourani, 2004). As
such, Islamic finance encourages distribution of loss and profit among business partners
which conforms to Islamic principles (Gunn and Shackman, 2014).

Malaysian’s approach towards financial innovation in 1993 resulted in the establishment of

dual banking system, that is, conventional banking system and Shariah-based or Islamic
banking system. This is a very unique system as they operate side by side. Standards and
guidelines are developed by Shariah Advisory Council (SAC) in accordance with Shariah-
based principles (Ahmad and Azhar, 2015). No doubt that Malaysia is one of the pioneers in
Islamic finance.

The Shariah Advisory Council (SAC) is a reference body and an advisor to Bank Negara
Malaysia (BNM). It holds the responsibility of confirming and ensuring that all Takaful and
Islamic banking products are in full compliance to Shariah-based principles. The screening
methods of SAC is important in ensuring that all shariah approved stocks strictly follow the
stipulated guidelines and principles of Islam. The SAC consistently confirms and checks
fundamentals of those Shariah-compliant companies periodically (Adam and Bakar, 2014).

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The conventional financial system plays an important role in facilitating the flow of funds
from surplus economic units (financial intermediaries) to the deficit units or borrowers
(Kumar and Kaushal, 2017). With respect to Shariah-compliant companies, their borrowing
activities are allowable but the use of interest (or Riba) is strictly prohibited in the teaching of
Islam (Gunn and Shackman, 2014; Farooq, 2012). As such, SAC imposes a very clear
guideline that every Shariah-compliant company must maintain its debt equity ratio to a limit
that is less than 33 percent (Ahmad and Azhar, 2015). Having understood the characteristics
of these Shariah-compliant companies, a comprehensive study on capital structure
determinants of all listed firms at Bursa Malaysia is warranted (Thabet et al., 2017; Ahmad
and Azhar, 2015; Thabet and Hanefah, 2014).

This paper seeks to explore a new frontier of knowledge by examining the determinants of
capital structure involving all Shariah and non-Shariah companies which are listed at Bursa
Malaysia main market. Specifically, this empirical study only selects profitable companies
from Bursa over a period of 12 years from 2005 to 2016. At the end of the process, a total
number of 446 listed companies are identified and considered for further analysis.

Literature Review

A modern study on capital structure was initiated by Modigliani and Miller (1958). Fondly
known as MM Theory, this theory ends up with three propositions. MM I hypothesize that
under a perfect capital market assumption; a firm decision related to capital structure is
independent from its market value and related cost of capital. Essentially, a perfect capital
market exists when there is an absence of transaction cost, agency and bankruptcy cost, taxes
and symmetry of information. With regard to MM II, firm’s leverage has no effect on
weighted average cost of capital (WACC). Ultimately, MM III stipulates that firm’s value is
not affected by firm’s dividend policy (Hussain, 2015; Abdul Jamal, 2013).

Another celebrated capital structure theory is known as the Trade-off Theory. This theory
suggests that firms can choose their capital structure by balancing the benefits of debt,
especially tax savings and with the costs of debt such as bankruptcy cost (Abdeljawad et al.,
2013). In short, Trade-off Theory brings an attention to cost of financial distress as well as
agency cost (Abdul Hadi, 2017). The third theory is referred to as Pecking Order Theory and
as the name suggest, it focuses on priority of internal financing followed by debt and lastly
equity financing. Pecking Order Theory advocates that financing cost would increase with the
asymmetric information and does not put an emphasis on optimal capital structure (Luigi and
Sorin, 2009; Mostafa and Boregowda, 2014).

Pandey (2001) investigates the determinants of capital structure of Malaysian firms by

providing new insights by relating capital structure with market power and profitability.
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Ozkan (2001) highlights the observed target determinants of firm’s capital structure and the
process of adjustment to achieve selected target capital structure. Deesomsak et al. (2004)
study the determinants of capital structure in Asia Pacific countries and find that capital
structure is dependent upon environment or industry in which firms are operating. Gill et al.
(2009) analyze the determinants of capital formation for the service industry in the United
States and examine the impact of income tax, size, profit and growth on return on equity
(ROA) in which their findings support that leverage is an indirect relation to firm’s
performance.

Saad (2010) explores the best practices of firm's capital structure in Malaysia and finds that
substantial relationship to the firm’s capital structure and organizational success exists. Zabri
(2012) investigates capital structure determinants of Malaysian small and medium size
enterprises (SMEs). The results of his investigation reveal that SMEs and large firms’ capital
structure determinants are almost similar. Mohammadzadeha et al. (2013) employs Static
Trade-off Theory and Pecking Order Theory and acknowledges the negative association
between capital structure and profitability. A study by Saarani and Shahadan (2013) aims at
analyzing capital structure determinants of Malaysian small, medium and large firms by
considering the relevance of Trade-off Theory and Pecking Order Theory.

Yusuf et al. (2013) uses debt ratio as a proxy for capital structure in their study upon
Malaysian electronic and electric sector. Hussain and Miras (2015) also uses total debt ratio
as a variable of interest on their study on Malaysian food producers. They assign size,
growth, liquidity and asset tangibility as independent variables. Mursalim et al. (2017)
conduct a study on capital structure determinants of Thailand, Indonesia and Malaysia listed
companies and reveal that company size, profitability and volatility play significant roles in
defining the variation of a firm’s capital structure. Their results show that a firm’s capital
structure is significantly associated with a firm’s performance.

Data and Methodology

From the onset, this study considers a total of 558 companies across all sectors of Bursa
Malaysia main market (with the exception of the financial sector) over a period of 12 years
from 2005 to 2016. As the filtering process involves selection of profitable companies from
the Bloomberg database, only 446 listed companies are identified and subsequently divided
into Shariah and non-Shariah categories. There are 351 Shariah-compliant companies, while
the non-Shariah category is made up of 95 companies. Technically, the research model is
estimated using Dynamic Panel Data Analysis via Generalized Method of Moments (GMM)
approach and expressed as follows:

DEit= α0 + δDEi,t-1 +β1TAit+β2FAit+β3CAit+β4Sizeit+β5ROEit+β6EPSit+µit…..(1)

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Where, α, δ and β are the model’s coefficients and the individual and time specific effects are
represented by i and t respectively. DE represents the variable of interest or the firm’s capital
structure, while DEi,t-1 is the lagged dependent variable. The six explanatory variables are
made up of total assets (TA), fixed assets (FA), current assets (CA), sales (Size), return on
equity (ROE) and lastly earning per share (EPS). Finally, µit denotes the model’s error term.
This empirical model helps explain the theoretical relationships between capital structure and
its determinants.

The two-step GMM is mobilized as an estimation model for testing the determinants of firm’s
capital structure across the Shariah and non-Shariah spectrum. This method provides the
panel data (cross-sectional and time series data) with efficient econometric estimators. GMM
is a dynamic estimation model and it is capable of reducing and easing up endogeneity
problem. Endogeneity is the correlation between the parameters or variables with the error
term. This GMM approach controls the endogeneity problem by employing unobservable
shocks in the cross-sectional component. To ensure the validity of GMM results, two
important diagnostic tests are performed – serial correlation test on the error terms plus the
test for exogeneity of the instruments via the Sargan test. The GMM approach is
commendable because it improves not only the estimation efficiency but also reduces the
multicollinearity problem while increasing the degree of freedom between the explanatory
variables. Also, GMM’s panel data approach yields the advantage of solving unobserved
firm-specific effects. In short, GMM is a method that alleviates the deformation caused by
fixed effects, simultaneity and endogeneity.

Empirical Findings

The balanced panel data is analyzed in SAS programs and the descriptive statistics for both
Shariah and Non-Shariah categories are presented in Table 1 and Table 2 below.

Table 1: Descriptive Statistics of 351 Shariah-Compliant Companies

Variable Maximum Minimum Mean Median Mode Std Dev
DE 37.8510 0.0045 0.7976 0.5852 0.8048 0.9683
TASSET 132,902.20 3.7850 1,708.29 360.08 529.45 6811.26
FASSET 101,685.40 0.0019 778.05 115.97 129.07 4343.78
CA 81,459.81 3.7850 615.68 174.14 40.55 2260.92
SALES 47,254.50 3.5058 920.59 252.07 385.02 3100.21
ROE 148.3993 0.0002 0.1807 0.0857 0.0073 2.8873
EPS 39.27 0.0002 0.1736 0.0777 0.0200 0.7884

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Table 1 shows that the mean DE is approximately 0.80, while its median stands at lower level
0.59. The maximum value of TASSET for the Shariah-compliant category is about RM133
million, but its mean value settles at much lower level of RM1.708 million. The mean value
of CA and SALES are registered at RM615,000 and RM920,000 respectively. The mean
ROE is seen at much lower percentage of 0.18%, followed by the mean EPS of 0.17 cent.

Table 2: Descriptive Statistics of 95 Non-Shariah Companies

Variable Maximum Minimum Mean Median Mode Std Dev
DE 23.8652 0.0019 0.9059 0.5230 0.0504 1.4466
TASSET 92,545.80 14.9184 2,685.04 454.75 139.85 8740.26
FASSET 42,830.40 0.0030 1,106.84 118.83 0.0030 4130.62
CA 32,416.00 6.7694 965.65 202.14 1336.72 3054.23
SALES 20,049.17 0.0680 1,057.41 225.24 10.28 2573.98
ROE 40.1296 0.0006 0.1593 0.0761 0.0218 1.2183
EPS 72.3870 0.0001 0.2556 0.0770 0.0206 2.2503

With respect to the non-Shariah companies, their mean DE is higher than its counterpart at
1.02. Interestingly, the median of DE is slightly lower at 0.523 as compared to the Shariah
companies. Looking at the DE distribution, its standard deviation of 1.446 seems much
higher than the Shariah companies. In terms of tangibility, the mean TASSET, FASSET and
CA are found to be much higher than the Shariah counters. As for the EPS, the non-Shariah
category outperforms its counterpart.

Table 3: GMM Estimation on Capital Structure Determinants of Shariah-Compliant

Companies:
GMM: First Differences Transformation
Estimation Method: Two-Step GMM
Parameter Estimates

Standard
Variable Estimate t Value P-value
Error
Intercept -0.0268 0.0215 -1.25 0.2116
lde_1 0.2449 0.0881 2.78 0.0054*
ltasset 0.0606 0.2963 0.20 0.8379
lfasset 0.0296 0.1533 0.19 0.8466
lca 0.7418 0.3049 2.43 0.0150*
lsales 0.2053 0.2237 0.92 0.3587
lroe 0.1603 0.1089 1.47 0.1412
leps -0.0615 0.0580 -1.06 0.2894
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*significant at 5%

Table 3 demonstrates the estimation results of the Shariah-compliant model. It is evident that
the coefficient of lagged dependent variable is significant at 5%, which suggests that the
Dynamic Capital Structure does explain a firms’ financing decisions. It is worthy to note that
the value of this coefficient or the speed of adjustment (δ=0.25) is quite high, laying between
0 and 1. There is also a positive significant relationship between CA and firm’s capital
structure. As the level of CA expands, the firm has a better chance to increase its borrowings.

Table 4: Sargan Test

Test for Exogeneity of Instruments
H0: Model and over-identifying conditions are correctly specified
H1: Model and over-identifying conditions are not correctly specified
DF Statistics Prob > ChiSq
26 32.06 0.1911

The Sargan test is a test of validity of the instrument variables. It is a test of the over
identifying restrictions in a statistical model. The null hypothesis states that the instrumental
variables are uncorrelated to some set of residuals, and therefore they are accepted as valid
and credible instruments. From the diagnostic test above, the null hypothesis is cannot be
rejected and this result confirms that the instrument variables are valid.

Table 5: AR(m) Test

Test of Autocorrelation on Error Terms
H0: There is no serial correlation on error terms
H1: Presence of serial correlation on error terms
Lag Statistic Pr > Statistic
1 -3.68 0.9999

The second diagnostic test is the AR(m) test. The test checks for the presence of serial
correlation on the model’s error terms. The p-value of AR (m) test is 0.9999 and it is greater
than the α of 5%. It is now obvious that the null hypothesis cannot be rejected and the
absence of autocorrelation problem is therefore confirmed.

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Table 6: GMM Estimation on Capital Structure Determinants of Non-Shariah-Companies

GMM: First Differences Transformation
Estimation Method: Two-Step GMM
Parameter Estimates

Standard
Variable Estimate t Value P-value
Error
Intercept -0.0303 0.0264 -1.15 0.2507
lde_1 -0.3341 0.0580 -5.76 <0.0001*
ltasset 0.6822 0.2256 3.02 0.0026*
lfasset 0.0963 0.0215 4.48 <0.0001*
lca 0.1000 0.1725 0.58 0.5619
lsales 0.0725 0.1524 0.48 0.6340
lroe -0.0599 0.1142 -0.52 0.5999
leps 0.0005 0.1339 0.00 0.9964
*significant at 5%

The estimation results of non-Shariah model is presented in Table 6. Similar to its

counterpart, the coefficient of lagged dependent variable is also significant at 5% level. This
implies the relevance of Dynamic Capital Structure whereby firms at Bursa Malaysia do
change their financial strategies to achieve target capital structure. Both TA and FA are
positively and significantly related to firm’s capital structure. In other words, the firm’s
borrowing capacity increases in tandem with its tangibility.

Table 7: Sargan Test

Test for Exogeneity of Instruments
H0: Model and over-identifying conditions are correctly specified
H1: Model and over-identifying conditions are not correctly specified
DF Statistics Prob > ChiSq
26 15.60 0.9453

As for the non-Shariah model, its GMM’s diagnostic tests are summarized in Table 7 and
Table 8. The null hypothesis of Sargan and AR(m) tests cannot be rejected and these results
confirm that the instrument variables are valid coupled with the absence of serial correlation
on the model’s error terms. As such, the predictive modelling from this GMM approach is
therefore valid and credible.

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Table 8: AR(m) Test

Test of Autocorrelation on Error Terms
H0: There is no serial correlation on error terms
H1: Presence of serial correlation on error terms
Lag Statistic Pr > Statistic
1 1.62 0.0524

The test results from Shariah and non-Shariah models clearly show the relevance of Dynamic
Capital Structure theory and Trade-Off theory in explaining variations of DE ratio or
leverage in Bursa Malaysia companies. From the estimation results of both models,
tangibility and liquidity appear relevant in influencing firm’s choice of financing. Secondly,
the study posits that financial managers are free to readjust their leverage level periodically so
as to achieve their firm’s optimal capital structure.

Conclusion

There is no doubt that this study has presented some new insights on the characteristics of
Shariah-compliant companies and their nature of business financing. The empirical findings
reveal that current asset is the only significant capital structure determinant for the shariah-
compliant category. With respect to the non-Shariah companies, total assets and fixed assets
are the two significant determinants. It is worthy to note that the lag dependent Debt-Equity
is also significant for both Shariah and non-Shariah categories. The significant role of this
lag dependent variable suggests the importance of dynamic capital structure in explaining
variations in capital structure of publicly listed companies in Malaysia. Similarly, the
significant functions of current assets and fixed assets directly implies the relevance of Trade-
Off theory in explaining a firm’s choice of capital structure. In terms of profitability and
value of total assets, the non-Shariah companies are performing better than their counterparts.
However, it is important to note that this study is subject to survivorship bias as those loss-
making companies have been entirely excluded from the analysis.

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