OPTIMAL CAPITAL STRUCTURE PROPORTION FOR INDONESIAN INFRASTRUCTURE SECTOR: COMPARATIVE STUDY OF MODIGLIANI-MILLER THEORY, MODERN PORTFOLIO THEORY, AND AGENCY THEORY

• Main Author: Iqbal Sulthan Akbar, Muhamad
• Format: Final Project
• Language: Indonesia
• Online Access: https://digilib.itb.ac.id/gdl/view/66114
• Institution: Institut Teknologi Bandung

Capital structure is one of the most important financial decisions for businesses to reach their objectives. Based on Ardalan (2017), capital structure is the mixture of debt and equity to finance a company. The capital structure that maximizes the value of the firm is called the optimal capital structure. Optimal capital structure maximizes the value by minimizing the weighted average cost of capital–correlated with the long-term goal of business activities to maximize the value of the firm. Despite debt being a cheaper financing option, excessive debt poses financial risks that make equity important. This presents an urgent need for companies to have the optimal capital structure. Unfortunately, according to Myers (2001), there is no universal optimal capital structure theory to implement today. Several theories are useful under certain conditions but do not present exact debt and equity proportions to apply directly to a company. Capital structure is sector-specific. Using Indonesian Infrastructure sector data, this research aims to address the consensual gap of which optimal capital structure is the most suitable to implement (specifically) in the infrastructure sector. The author selects which is the best out of three most famous theories: Modigliani-Miller (MM), Modern Portfolio, and Agency based on which gives the smallest WACC. All theories look for two main variables: cost of debt and cost of equity. Cost of debt is all sought based on effective interest rate while the cost of equity’s calculation differs by theory: MM with fixed formulas, Modern Portfolio Theory using CAPM, and Agency using stock return. Data analysis also differs: MM through manual debt-to-equity simulation, Modern Portfolio Theory through SOLVER function on Microsoft Excel, and Agency Theory through regression. Based on Modigliani-Miller, the optimal structure is 69.97% debt and 30.03% debt which gives 5.0688% WACC. Based on Modern Portfolio Theory, which is done through two simulations: pegged return and pegged variance suggests 40.62% debt and 59.38% equity with 9.7711% WACC and 66.17% debt and 33.83% equity with 8.1301% WACC respectively. Based on Agency Theory, the optimal structure is 60.63% debt and 39.37% equity which gives 5.9394% WACC. MM Theory’s result is invalid because it was chosen out of the necessity of satisfying loan-to-value ratio and did not obey pecking order theory constraints. This concludes that the one generating smallest WACC is Agency Theory to be the most suitable optimal structure theory to implement in the Indonesian Infrastructure sector. Author suggests companies in this sector adopt Agency Theory when calculating optimal capital structure especially if they have abundant historical data and insight about debt-to-equity ratio along with the WACC. This theory’s methodology will be more accurate with more inputs. Companies opting for Agency Theory should have 60.63% debt and 39.37% equity in order to minimize WACC to 5.9394%. If companies want to set a target for their WACC, the author recommends Modern Portfolio Theory with SOLVER as the debt & equity proportions rely on constraints set before the tool is run. However, if the company has scarce historical data about capital structure, author suggests MM Theory with fixed formulas to work with and just need to plug-in some assumptions. This research shall lay the groundwork in deciding which optimal capital structure is best to implement especially in the Indonesian infrastructure sector–solving the theoretical gap. Through this research, firms have the literature validation on choosing what optimal capital structure theory to use in order to maximize their value. Keywords: Capital Structure, Weighted Average Cost of Capital, Infrastructure Sector, Maximizing Value of Firm