International Review of Economics and Finance xxx (xxxx) xxx

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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

Asymmetric capital structure speed of adjustment, equity

mispricing and Shari’ah compliance of Malaysian firms
Hafezali Iqbal Hussain a, b, Mohsin Ali a, *, M. Kabir Hassan c, Rwan El-Khatib d
a
Taylor’s Business School (TBS), Taylor’s University Lakeside Campus, 1, Jalan Taylors, Subang Jaya, 47500, Selangor, Malaysia
b
Visiting Professor at University of Economics and Human Sciences, Warsaw, Poland
c
Professor of Finance and Hibernia Professor of Economics and Finance and Bank One Professor in Business, Department of Economics and Finance
University of New Orleans, New Orleans, LA, 70148, USA
d
Al Dhaheri Chair in Islamic Finance College of Business Zayed University, P.O. BOX, 19282, Dubai, United Arab Emirates

A R T I C L E I N F O A B S T R A C T

JEL classification: Traditionally, equity mispricing has been documented as an important determinant of speed of
G30 adjustment to target leverage levels. More recently, the impact of Shari’ah compliance has been
G32 shown to significantly affect capital structure decisions. In this paper, we explore the effect of
G15
equity mispricing in Shari’ah compliant (vs. non-compliant) firms. We conduct our study on a
Keywords: comprehensive sample of Malaysian firms from year 1998–2016. We show that established
Capital structure
findings in the dynamic trade-off theory do not hold for Shari’ah compliant firms. Shari’ah
Speed of adjustment
compliant firms increase their reliance on equity financing at greater levels than non-compliant
Dynamic trade-off theory
Equity mispricing firms when they are above target levels and equities are overpriced. In contrast, for Shari’ah
Shari’ah compliance compliant firms below target levels and where equity is under-priced, the rate of adjustment is
Islamic capital markets slower than non-compliant firms. Our findings suggest that managers of Shari’ah compliant firms
Malaysian firms are inclined to time the equity market when above target levels to capture the impact of lower
costs of equity during periods of over-valuation of equity. However, those managers tend to be
reluctant to resort to debt financing when below target leverage even in the presence of equity
under-pricing.

1. Introduction

In this paper, we conduct an empirical test of speed of adjustment to target leverage levels of Malaysian firms based on traditional
factors such as the nature of deviation from target levels (above or under target) and equity mispricing, in addition to exploring the
impact of compliance to Shari’ah. In order to estimate our model, we assume that managers are able to exploit potential mispricing in
the equity market given the existence of information asymmetry.
Based on the trade-off theory of capital structure, firms increase debt levels in order to capture the potential benefits of borrowing up
to a certain point after which the marginal costs of increasing debt outweighs the marginal benefit. This point is referred to as an optimal
level or target leverage level. Empirical studies find that firms do indeed have a target level (Haron et al., 2013). However, firms are
unable to adjust perfectly to target levels due to the incurrence of adjustment costs which tend to be exogenous in nature and thus act as
an impediment (Flannery & Rangan, 2006; Haas & Peeters, 2006). Firms also tend to face limitations on access to funds as well as

* Corresponding author.
E-mail addresses: hafezali.iqbalhussain@taylors.edu.my (H.I. Hussain), mohsin.ali@taylors.edu.my, mohsin.ali121@gmail.com (M. Ali),
mhassan@uno.edu (M.K. Hassan), rwan.elkhatib@zu.ac.ae (R. El-Khatib).

https://doi.org/10.1016/j.iref.2020.10.017
Received 23 March 2020; Received in revised form 3 October 2020; Accepted 20 October 2020
Available online xxxx
1059-0560/© 2020 Elsevier Inc. All rights reserved.

Please cite this article as: Hussain, H. I. et al., Asymmetric capital structure speed of adjustment, equity mispricing and Shari’ah
compliance of Malaysian firms, International Review of Economics and Finance, https://doi.org/10.1016/j.iref.2020.10.017
H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

expected bankruptcy costs when adjusting to target debt levels (Elsas & Florysiak, 2011). In addition, the institutional factors of different
€
capital markets also determine firms’ ability to reach target levels (Oztekin & Flannery, 2012). Moreover, Warr et al. (2012) further
motivate our study by highlighting another factor affecting the speed of adjustment to target levels which is equity mispricing. Recently,
some studies (Thabet et al., 2017) report that Shari’ah compliant firms tend to adjust to target levels in a non-linear manner due to the
restrictions exerted on non-compliant financing sources (interest based). However, those studies do not include the impact of equity
mispricing. Hence, in our study, we examine the impact of both equity mispricing and Shari’ah compliance on speed of adjustment in
order to capture the interaction between those factors which can act as impediments as well as catalysts to adjustments to target leverage
levels.1 In this study, we try to address the important question of whether or not Shari’ah compliant firms are inclined to issue equity
during periods of overvaluation and does this behaviour coincide with target adjustment behaviour? The paper compares the timing
attempt by managers for both compliant and non-compliant companies whilst capturing target adjustment behaviour which is intended
to capture the bankruptcy cost. In other words, we try to evaluate the ability and or incentive to time equity markets given restrictions
placed by Securities Commission, Malaysia i.e. the debt threshold which requires asset-backed transactions whilst taking into account
the cost of debt itself. Using financial data from Datastream, we study a sample of Malaysian firms from 1998 to 2016. We chose the
Malaysian sample because the Malaysian market is the only well - developed fully functioning Islamic capital market (Bacha & Abdullah,
2017). Our final sample includes 689 firms in 8296 firm/year observations.
In our empirical methodology, we follow Elliott et al., 2007, 2008, to measure the intrinsic value of equity using the residual income
model. Furthermore, for robustness, we obtain data from Bloomberg to use analysts forecasted earnings as an alternative measure of
equity mispricing. We model the target levels at lead levels (Target leveragetþ1) using two approaches; the Fama and French (2002) as
well as the Blundell and Bond (1998). We use a two stage Generalized Method of Moments (GMM) model to estimate the speed of
adjustment by first estimating target leverage using known determinants of leverage such as: firm size, asset tangibility, market-to-book
ratio, share price performance, non-debt tax shield, and industry median leverage (to estimate both book and market target leverage)
and then in the second stage, we bifurcate the target level measure based on the equity valuations.
In line with the prior literature, our findings suggest that Malaysian firms adjust to target levels. In addition, the rate of adjustment is
more rapid when firms are overvalued and exceed their target levels. However, the rate of adjustment is also dependent on the nature of
Shari’ah compliance. Our findings provide evidence of compliant firms increasing reliance on equity financing at greater levels than
non-compliant firms when they are above target levels and equities are overpriced. The evidence does imply that Shari’ah compliant
managers are more inclined to resort to external financing when conditions are favourable in the equity markets which in turn reduces
relative leverage levels and thus brings firms closer to target levels. On the other hand, in firms below target levels, we find that
managers of non-compliant firms tend to increase reliance on debt financing at greater extents relative to their compliant counterparts
suggesting that their ability to increase debt levels at ease does provide advantages in not having to resort to equities during periods of
under-pricing. In addition, restrictions on debt may lead Shari’ah compliant firms to preserve financial slacks for unforeseen circum-
stances. The paper proceeds as follows. Section 2 discusses the relevant literature and standards required to meet Shari’ah compliance.
Section 3 presents the empirical methodology and Results. Section 4 concludes.

2. Literature review and standards for Shari’ah compliance

In this section, we provide a review for the literature pertaining to the target leverage adjustment of firms and the impact of equity
mispricing. We also explain the restrictions emplaced on debt financing arising from Shari’ah compliance.

2.1. Adjustment to target leverage

Nor et al. (2011) find that consistent to evidence presented in other countries, managers of Malaysian firms do consider target
leverage in determining their capital structure decisions. The literature documents that target adjustment behaviour is limited by
adjustment costs as well as managers attempting to time security issues in the capital markets (Leary and Roberts, 2005; Faulkender
et al., 2007). In addition, in large clumped issues, the level of information asymmetry also provides incentives for managers to time the
equity market (Chang et al., 2006). Binsbergen et al. (2010) provide a model to explain target adjustment behaviour whereby firms
above target levels tend to have larger costs of deviation in relation to firms below target levels. Furthermore, Byoun (2008) presents
empirical evidence whereby over-levered firms tend to potentially face larger costs of financial distress and thus would be inclined to
adjust to target levels at more rapid rates. In addition, equity mispricing also impacts target adjustment behaviour whereby over-levered
firms are more inclined to adjust to target levels during periods of overvaluation whilst under-levered firms increase debt to reach target
levels during periods of undervaluation (Warr et al., 2012). Hippler et al. (2020) shows that using a partial adjustment model with the
US mutual funds data, the mutual fund manager’s portfolio adjustment decision is one of a tradeoff between the benefits of optimal
portfolio adjustment and the costs associated with that adjustment.
Dang et al. (2012) argues that firms adjust to target levels in a non-linear manner. Hussain et al. (2017) find that Malaysian firms
often deviate from target levels and adjustment is motivated by target adjustment behaviour as well as managers timing attempts. They
also add that Shari’ah compliance influences speed of adjustment to target levels. Given the findings in the literature, the main
contention that remains unexplored is the rate of adjustment rather than the target adjustment behaviour per se. Our paper contributes

1
Hussain et al. (2017) study the impact of Shari’ah compliance on speed of adjustment, however, they use the present value of bankruptcy costs as
a proxy for cost of adjustment.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

to the literature by filling in this gap and taking into account recent developments whereby firms tend to adjust at differing rates
depending on the nature of deviation from target (above target levels versus below target levels) whilst incorporating the impact of
equity mispricing as well as Shari’ah compliance. Thus we hypothesize that Shari’ah compliance interacts with equity mispricing in
influencing firms’ ability to revert to target levels given that both factors influence adjustment costs as they have a direct impact on
firms’ ability and tendency to issue debt as well as equity.

2.2. Equity mispricing and its impact on capital structure decisions

Based on the model proposed by Baker and Wurgler (2002) for market timing, a firm’s current capital structure is based on an
accumulation of previous attempts to time the equity market. Thus, the authors argue that firms tend to opt of equity financing during
periods of overvaluation whilst resorting to debt issues when share prices are low. In addition, the authors show that the timing attempts
have a long term impact on firms’ capital structure given that equity market timing influences leverage levels in the long-run. Assuming
that mangers are acting in line with shareholders’ wealth maximization, the ability to time equity markets provides additional value to
existing shareholders as managers seem to find windows of opportunities which are a result of investors inability to capture information
fully when making investment decisions (Hansen, 1982). Empirical evidence supports this notion by showing that managers’ timing
attempts can increase shareholders’ wealth by up to 4% (Warusawitharana & Whited, 2015). Hovakimian (2006) further finds that
seasoned equity offerings are strongly correlated to equity prices, suggesting that managers do indeed time the market. Further in-
ternational evidence on timing behaviour by firms is evidenced in Fung et al. (2009) where managers tend to increase equity issues
during periods of high valuations and conversely increase reliance on debt issues when equity prices are repressed. Bolton et al. (2013)
further argue that managers act rationally by timing the equity market and tend to build up cash reserves during favourable equity
markets in order to mitigate financial constraints. In addition, the speed at which firms go public during favourable and unfavourable
markets has a positive (and negative) correlation with returns (Plotnicki & Szyszka, 2014).
On the other hand, several empirical studies have found Results contrasting the market timing theory. Flannery and Rangan (2006)
argue that bulk of changes in debt levels is explained by the trade-off theory as compared to the market timing theory. In addition,
managers tend to revert to pre-IPO debt levels in two years after the IPO event suggesting that market timing decisions are reversed in
the long-run (Alti, 2006). Hussain (2014) find that firms opt for issuing equity in the times of minor overvaluation and resort to issuance
of debt during times of severely depressed share prices. Allini et al. (2017) show that Egyptian firms’ issuance behaviour is influenced
with financing the deficit rather than timing the equity market. Thus, inconclusive evidence exists on the relevance of market timing
theory in rationalising capital structure decisions.

2.3. Shari’ah compliance

In Islamic finance, transactions have to comply with the Islamic law, hence, they should not include usury (Riba), gambling (Maysir),
excessive uncertainty (Gharar), or involve prohibited activities (alcohol, riba, etc.2) Thus, in Shari’ah compliant companies, debt is
determined in a significantly different way relative to the conventional model of explaining debt (Aliyu et al., 2017; Hassan & Aliyu,
2018; Hassan, Aliyu and Hassan, 2019; Hassan et al., 2019, 2020, 2020; Hassan et al., 2020; Zaher & Kabir Hassan, 2001). This is to
conform to most governing bodies and organizations such as the Accounting and Audit Organization for Islamic Financial Institutions
(AAOIFI) which places restrictions on debt via a set of guidelines (Abdul Rahman et al., 2010; Hassan, Aliyu, & Hussain, 2019). Alnori,
F., & Alqahtani, F. (2019) is one of the recent studies which studied the impact of capital structure on speed of adjustment of Saudi firms.
They concluded that due to financial restrictions, compliant firms have slower speed of adjustment.
In our paper, we study a sample of Malaysian firms because the Securities Commission (SC) of Malaysia places similar restrictions on
the issue of debt financing for firms listed on the Bursa Malaysia (Malaysian Stock Exchange) in order for them to be classified as
Shari’ah compliant. SC restriction requires that Shari’ah compliant firms limit their debt financing (interest-based) so that their debt to
equity ratios not exceed a threshold of 33%. The SC provides updates on the nature of compliance twice a year. In addition compliance
requires additional restrictions on interest income to not exceed 5% of the total income earned. The SC provides further non-financing
restrictions based on the Shari’ah requirements for activity benchmarks which influence revenue generation (i.e. sales) by firms. Other
jurisdictions like Pakistan, UAE etc adopt to slightly different Shari’ah screening methodologies, but the most relevant criteria related to
our study i.e. debt to asset ratio of not greater than 33% is adopted by almost all the jurisdiction. This make the findings of this study
generalizable in different jurisdictions.
Thus, these restrictions are expected to have different implications on firms’ capital structure decisions (Thabet et al., 2017) given
that Shari’ah compliant firms’ managers will have different motivations compared to their non-compliant counterparts. In addition, in
the event that a firm becomes non-compliant, Islamic fund managers would be forced to liquidate their shareholdings if they are ‘in the
money’. This would suggest that potential non-compliance could lead to weakness in share prices which provide incentives for managers
to remain compliant. However, it would be quite possible for a firm to re-enter the compliant list after a 12 month gap by altering the
composition of debt (compliant versus non-compliant sources), given that financial reports would only be released on a yearly basis.

2
For a comprehensive review on Islamic finance, please see Ayub (2007).

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3. Empirical methodology and results

We use Datastream to obtain financial data of Malaysian publicly listed firms in a period spanning from 1998 to 2016. We start our
study in 1998 because the Securities Commission of Malaysia started classifying Shari’ah compliance by the end of 1997. Following the
norm in the literature, we exclude the financial firms (Thabet et al., 2017), and eliminate outliers by winsorizing the sample at the first
and 99th percentiles. Estimating the speed of adjustment utilizing our two-stage system GMM method (which will be explained later in
section 3.2) Results in a four-year survivorship bias in the sample selection. As a result of those data filters and requirements, our final
sample consists of 689 firms in 8296 firm/year observations. We follow previous studies in defining our main explanatory and control
variables (see for example: Haron et al., 2013). We report descriptive statistics on those variables in Table 1.

3.1. Measuring equity mispricing

We measure the intrinsic value of equity using the residual income model (following Elliott et al., 2007, 2008). Under this approach,
we divide the intrinsic value by the current share price in order to capture the mispricing element. D’mello and Shroff (2000) outlines
the advantages of the residual income model in measuring equity mispricing. In addition, to eliminate the possibility of capturing
growth options of firms rather than timing attempts by managers, we disintegrate market-to-book ratio in order to detach the
component of growth from the valuation component (Rhodes-Kropf et al., 2000). We then only utilize the valuation component in our
model. Elliott et al. (2007, 2008) define the intrinsic value as follows:

X
T
ð1 þ kÞT
IV0 ¼ BE0 þ ð1 þ kÞ1 EE0 ½It  K  BEt1 þ TV (1)
t¼1
k

The authors further define terminate value, TV as follows:

EE0 ½ðIr  k  BEt1 Þ þ ðItþ1  k  BET Þ

TV ¼ (2)
2

where IV0 is the intrinsic value to be estimated. BE0 is defined as the equity book value whilst k represents the cost of equity and EE0
represents the expected earnings. The previous fiscal year is treated as time 0 whilst T is set to equal to 2 years. Our study further draws
from the authors in order to incorporate 3 years of earnings based on future growth.
The residual income is not based on the raw earnings data but captures abnormal earnings (essentially capturing Economic Value
added) and thus 3 years of data is sufficient to evaluate growth opportunities of firms (Elliott et al., 2007). In line with them, we employ the
assumption of perfect foresight into the residual income model (as done by D’mello & Shroff, 2000). Therefore, BE would be defined as the
book value of equity whilst Ii is income before extraordinary items. Similar to Elliott et al. (2008) we utilize the ex-post realization of
earnings which allows us to maximize sample size, although this implies endogeneity in the model. This issue would however inhibit our
model from validating our hypothesis given that increase in debt levels would require mangers to commit to future interest payments. We
use Fama and French (1997) to estimate the k (cost of equity capital). Our findings do not differ if a single factor model is utilized.
Our model measures the risk free rate based on short-term Malaysian treasury bills. In addition, we estimate terminal value in
Equation (2) based on the average of the final 2 years in the series of data. Then, we further eliminate negative values, and thus assume
that managers do not continuously accept negative NPV projects. Similar to Elliott et al. (2007) we assume that managers have greater
levels of information relative to investors and thus assume perfect and unbiased foresight. Thus, the model employs future realized
earnings. The authors argue that this approach would not be biased given that the aim of the estimations is to calculate the deviation
from intrinsic values rather than trade based on the valuation estimates. Furthermore, for robustness, we use an alternative way of
defining equity mispricing based on analysts forecasted earnings (consensus) (Lee et al., 1999; D’mello & Shroff, 2000; Elliott et al.,
2007). To conduct those robustness tests, we gather data from Bloomberg using beginning of year values. However, our sample size is
significantly reduced given that the number of firms covered by analysts tends to be limited. The use of differing methods to measure
equity mispricing provides additional robustness whereby the perfect foresight model suffers from the implication that managers are

Table 1
Descriptive statistics.
Variable Mean Median Standard Deviation Min Max

Book Leverage (BL) 0.1964 0.2450 0.1488 0.0000 0.9625

Market Leverage (ML) 0.2689 0.2799 0.1827 0.0000 0.9536
Firm Size (SIZE) 5.2456 4.5648 1.2240 1.4508 9.2638
Tangibility (TANG) 0.5581 0.5624 0.1401 0.0000 0.9422
Market-to-book Ratio (MTB) 1.8019 1.9210 2.6801 0.2896 8.6259
Share Price Performance (SPP) 0.0108 0.0201 0.5624 0.8255 0.9638
Non-debt Tax Shield (NDTS) 0.0318 0.0201 0.0209 0.0000 0.4863

This table presents summary statistics on our main variables. BL is measured as the ratio of book debt divided by total assets. ML is the amount of book
leverage scaled by market value of equity plus book value of total debt. SIZE represents net sales in ringgit millions of 1998 (natural logarithm). TANG
represents tangible assets measured by ratio of net plant, property and equipment to total assets. MTB represents, market value-to-book value ratio,
which is the ratio of BV of total assets minus BV of equity plus MV of equity to BV of total assets. SPP is the share price performance i.e. the difference
share price at t minus share price at t-1 divided by share price at t-1. NDTS, non-debt tax shield is depreciation scaled by total assets.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

unbiased in their expectations of futures earnings. Thus, the model employs data which would have been unknown during the time
changes to capital structure were made. However, our model is aimed at measuring relative mispricing in between firms rather than
absolute mispricing per se. The model does not discriminate the cause of mispricing (driven by information asymmetry or investor
irrationality). Thus, the empirical model as well as the pursuing econometric tests only require that managers are aware of such potential
deviation from intrinsic values (regardless of the source of mispricing). In addition, we acknowledge the potential for perceived mis-
pricing rather than fundamental deviation from intrinsic values. It is important to note that managerial actions are driven by their/-
shareholders believe of mispricing (regardless of it being real or perceived mispricing) (Warr et al., 2012).

3.2. Modelling target leverage

To estimate target leverage levels at the lead level (tþ1), we use two different approaches to ensure robustness of Results. First, we
follow Fama and French (2002) and estimate target debt using Fama and MacBeth (1973) regression models. This method is based on
regressing target leverage as a series of cross-sectional observations on an annual basis, controlling for determinants of leverage and
including industry effects as follows:

Target Leveragei;tþ1 ¼ αt þ β1 SIZEi;t þ β2 TANGi;t þ β3 MTBi;t þ β4 SPPi;t þ β5 NDTSi;t

þβ6 INDLit þ εtþ1 (3)

where: our dependent variable Target Leverage is estimated using both book leverage (BL) and market leverage (ML) and determinants
of leverage include: firm size (SIZE), asset tangibility (TANG), market-to-book ratio (MTB), share price performance (SPP), non-debt tax
shield (NDTS) and industry median leverage (INDL) both for book and market leverage.3 All those variables are as previously defined in
Table 1. All control variables are lagged one year to limit the impact of reverse causality.
Results of estimation of Equation (3) are reported in Table 2 with book (market) leverage as the dependent variable in columns 1 and (2)
respectively. Our results are consistent with the literature, where size has a positive and significant coefficient in both models indicating
that the larger the firm is, the higher its debt capacity due to its implied diversification which leads to stable cash flows (Hovakimian et al.,
2001). Asset tangibility is also positively (and significantly when using market leverage in column 2) associated with leverage because firms
with more tangible assets can offer more collateral to secure borrowings (Flannery & Rangan, 2006; Warr et al., 2012). The coefficient on
market-to-book ratio is negative and insignificant in both book and market leverage models. This negative coefficient indicates that firms
are protecting future growth opportunities. That is why they tend to have lower target levels (Flannery & Rangan, 2006). Share price
performance is negatively (and significantly when using market leverage in column 2) associated with leverage suggesting that firms would
opt for debt in the event that share prices perform poorly (i.e. undervalued) (Haron et al., 2013). The non-debt tax shield has a negative and
significant coefficient in both columns 1 and 2 in-line with the trade-off view whereby firms with higher depreciation expenses would tend
to opt for lower levels of target leverage (Warr et al., 2012). The coefficient for the industry median leverage measure is positively sig-
nificant in both models indicating that specific industries do indeed have specific targets.
Next, as a measure of robustness, we utilize the 2-step model of GMM estimations (Blundell & Bond, 1998), where the autoregressive
model for target leverage can be expressed as follows:

Target Leveragei;tþ1 ¼ αt þ βTarget Leveragei;t þ γ½EXPLANATORY VARIABLESi;t

þπ i;t þ τi;t þ εtþ1 (4)

where Target Leveragei;tþ1 is the lead variable representing target leverage at time (tþ1) and is measured for both market and book
leverage. Target Leveragei;t is the lag variable which is based on the current actual level of debt at time (t),
γ½EXPLANATORY VARIABLESi;t is a vector of explanatory variables measured at lag levels (t), πi;t on the other hand captures the firm-
specific characteristics which are unobservable and thus considered to be time invariant (including potential for specific firm reputa-
tions as well as particularly talented management) and τi;t represents effects which could potentially bias Results and are considered to
be time specific (including unexpected swings in economic conditions as well as shifts in the inflation levels) and thus is systematically
affecting all firms. The error term (εt ) is assumed to have mean values of zero and be serially uncorrelated.
GMM seemed to be the most appropriate methodology considering our dataset contains annual observations from 18 years. The
model is regressed based on a 2-step GMM system in order to avoid biased coefficients arising in OLS or 2SLS estimation given that τi;t is
not directly observable and would potentially be correlated with other explanatory variables in the autoregressive model (Hsiao, 1985).
In addition, it is very likely that Yi;t would be correlated with πi;t resulting in inconsistent coefficients in the estimated model.,45

3
We use those controls following previous studies such as Hovakimian et al., 2001; Hovakimian & Li, 2011; Haron et al., 2013, among others.
4
A commonly used method to resolve the time invariant issues would be to estimate the model using the fixed effects approach. However, this
approach still suffers from inefficiencies given that the first differences of the leverage levels are expected to have a correlation with the first dif-
ferences of the error term which arises due to the endogeneity of explanatory variables utilized in the OLS model.
5
The GMM method (as proposed by Arellano & Bond, 1991) has also advantages over the instrumental variable approach (proposed by Anderson
& Hsiao, 1982) as it provides more efficient estimates (Arellano & Bover, 1995; Blundell & Bond, 1998). We use the two step GMM (rather than single
step) to control for heteroscedasticity and correlations in the error term over the observed time.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 2
Estimating target leverage at the lead level (tþ1).
Model (1) (2)

SIZE 0.0614*** 0.2891***

(0.0118) (0.0501)
TANG 0.1415 0.2311***
(0.1091) (0.0824)
MTB 0.0110 0.0011
(0.0304) (0.0009)
SPP 0.0091 0.0299***
(0.0212) (0.0084)
NDTS 0.1211*** 0.1924***
(0.0205) (0.0411)
INDL 0.3451*** 0.4133***
(0.1211) (0.1922)
CONST 0.0922*** 0.0012
(0.0081) (0.0010)

Adjusted R2 0.2241 0.3119

F – Test (p-values) 0.00 0.00
N 8296 8296

This table presents our estimation Results for target leverage. These results are based on a static
framework. ***, ** and * shows significance at 1%, 5% and 10% respectively. Target leverage
(tþ1) is the dependent variable. Book leverage results are shown in Column 1 and market leverage
results are shown in column 2. The mean coefficient represents the average of the coefficients for
10 annual regressions. Following Fama and French (2002), standard error is the standard deviation
of the regression coefficient divided by (10)1/2. Industry dummies [0, 1] are included in all re-
gressions. SIZE represents net sales in ringgit millions of 1998 (natural logarithm). TANG repre-
sents tangible assets measured by ratio of net plant, property and equipment to total assets. MTB
represents, market value-to-book value ratio, which is the ratio of BV of total assets minus BV of
equity plus MV of equity to BV of total assets. SPP is the share price performance i.e. the difference
share price at t minus share price at t-1 divided by share price at t-1. NDTS, non-debt tax shield is
depreciation scaled by total assets. INDL represents the firm’s median industry leverage.

Moreover, to ensure the validity of our instruments, we use the Sargan’s test to ensure the absence of higher-order serial correlation.
Finally, we correct for heteroscedasticity by using robust standard errors, and we correct for errors present in finite series of data in
dynamic panel data models following Windemeijer (2005).
Results of the estimation of Equation (4) are displayed in Table 3. Results are similar to those documented in Table 2 and this
provides further evidence of target adjustment behaviour given that the lagged leverage is positive and highly significant (at the 1%
levels) when using both book and market leverage as in columns 1 and 2, respectively.

3.3. Measuring the speed of adjustment

Given that firms tend to deviate from target levels, managers would be inclined to issue (repurchase) financial securities in order to
adjust to target levels. However, the ability to reach to the target level would be dependent on the costs of adjustment. Our main notion
in this paper attempts to capture both the cost of equity capital (based on the mispricing measure) as well as cost of debt (via restrictions
placed by Shari’ah compliance). Similar to Warr et al. (2012) we model the target levels at lead levels (Target leveragetþ1) based on the
Fama and French (2002) as well as the Blundell and Bond (1998) approach as explained in section 3.2. We contend that Shari’ah
compliance influences costs of debt in a similar way that equity mispricing influences costs of equity capital given that compliance status
tends to determine firms ability to adjust to target levels (Hussain et al., 2017). Guided by our empirical priori, we capture the speed of
adjustment based on the following equation (Flannery & Rangan, 2006):

Leveragei;tþ1  Leveragei;t ¼ γ½Target Leveragei;tþ1  Leveragei;t  þ εtþ1 (5)

Our approach of adopting the two-stage model allows econometric gains which suits the purpose of the test in this particular study
given that the objective is to measure the debt position relative to target levels. It could have been entirely possible to estimate the rate of
adjustment based on a single stage model as often applied in the literature based on the Blundell and Bond approach. However, our
approach overcomes weaknesses identified in the literature of partial adjustment models where the Results may fail to reject the null
hypothesis of no speed of adjustment (Chang & Dasgupta, 2009). In addition, it is possible that results could be spurious given the nature
of the analysis of fixed effects for historical data (Hovakimian & Li, 2011). Thus, our approach of utilizing a two-stage model as well as
identifying target levels based on 2 differing approach overcomes such limitations (Warr et al., 2012).
The difference between both measures captures the amount by which leverage ratios must change in order for firms to revert to
target levels. We further employ a two-stage model approach in order to capture the speed of adjustment (Warr et al., 2012). In the
second stage, we bifurcate the target level measure based on the equity valuations. We further simulate values for target leverage from
the reported coefficients in Tables 2 and 3 for each firm. The fitted values are then used to estimate the rate at which firms adjust to

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

Table 3
Dynamic panel data estimation: Robustness of estimation of target leverage at the lead level (tþ1).
Model (1) (2)

LEVERAGE 0.7011*** 0.7931***

(0.0311) (0.1190)
SIZE 0.0911 0.1525***
(0.1644) (0.0303)
TANG 0.1422 0.2022***
(0.1099) (0.0806)
MTB 0.0009 0.0045***
(0.5601) (0.0011)
SPP 0.0311*** 0.0441***
(0.0095) (0.0082)
NDTS 0.5699** 0.2802***
(0.3011) (0.0605)
INDL 0.2899*** 0.4101***
(0.0701) (0.1243)

Adjusted R2 0.6811 0.8122

Wald test (p-values) 0 0
Sargan test (p-values) 0.28 0.22
N 8296 8296

This table presents our estimation Results for target leverage. These results are based on a dynamic
framework. ***, ** and * shows significance at 1%, 5% and 10% respectively. Target leverage (tþ1) is
the dependent variable. Book leverage results are shown in Column 1 and market leverage results are
shown in column 2. In the estimations we include a lagged measure of leverage as the independent
variable. Standard errors are robust and are based on finite sample correction (Windmeijer, 2005).
Industry dummies [0, 1] and year dummies are included in all the regressions. SIZE represents net
sales in ringgit millions of 1998(natural logarithm). TANG represents tangible assets measured by
ratio of net plant, property and equipment to total assets. MTB represents, market value-to-book value
ratio, which is the ratio of BV of total assets minus BV of equity plus MV of equity to BV of total assets.
SPP is the share price performance i.e. the difference share price at t minus share price at t-1 divided
by share price at t-1. NDTS, non-debt tax shield is depreciation scaled by total assets. INDL represents
the firm’s median industry leverage.

target leverage based on the distance variable.6 The model to estimate the speed of adjustment is:

LEVERAGEi;tþ1  LEVERAGEi;t ¼ αt þ β½TARGET LEVERAGEi;tþ1  LEVERAGEi;t þ

γ½EXPLANATORY VARIABLESi;t þ εi;t (6)

Our model is aimed at estimating the distance variable (TARGET LEVERAGEi;tþ1  LEVERAGEi;t ) as it captures the amount that the
debt levels must change in order for firms to reach target levels. Thus, in the event that firm’s current levels are below target, the
distance variable would be positive and vice versa. Based on the model, if firms are able to adjust perfectly to target, then the value of the
β coefficient would be unity. Given the findings of our empirical Results, we divide the sample into firms above and below target debt. In
above target level firms, we interact the distance measures (DIST) with two dummies, a dummy for equity overvaluation that has the
value 1 if equity prices are above intrinsic estimates (OVERVALD) and zero otherwise, as well as a dummy for Shari’ah compliance
(SCD) which gets the value 1 if the firms are classified as Shari’ah compliant and zero otherwise. In contrast, in firms which are below
target levels, distance measure (DIST) is interacted with an equity undervaluation dummy which takes the value of 1 if equity prices are
below intrinsic estimates (UNDERVALD) and zero otherwise, as well as a non-compliance dummy (NSCD) which takes the value of 1 if
firms are classified as non- Shari’ah compliant and zero otherwise. Our model is thus specified as follows:

LEVERAGEi;tþ1  LEVERAGEi;t ¼ αt þ βDISTi;t  OVERVALDorUNDERVALDi;t

SCDorNSCDi;t þ γ½EXPLANATORYVARIABLESi;t þ εi;t (7)

Table 4 presents Results Equation (7) based estimations. We estimate the model using the fixed effects method in order to control for
firm level factors which may have been omitted and are considered to be time invariant, hence leading to spurious correlation between
the distance measures, Shari’ah compliance as well as mispricing. This is due to the lead-lag nature of the model. In addition, fixed
effects allows to control for other differences that are firm specific such as superior management ability, unexpected shocks in the
economy as well as varying customer preference. Our results are robust to using clustering either on firm or time (Rogers, 1994) as well

6
See for example: Hovakimian & Li, 2011; Warr et al., 2012 on full arguments of the potential biasness of estimating speed of adjustment based on
the baseline dynamic model.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

as correcting for heteroscedasticity (White, 1980).

In columns 1 and 2 of Table 4 we display the Results for the full sample, followed by columns 3 and 4 (5 and 6) which includes a
subsample representing firm/year observations which are above (below) target levels, respectively. Similarly to Tables 2 and 3, we run
the models using two approaches for robustness, with results of estimating distance using the Fama and Macbeth (FM) models presented
in panel A and results of estimating distance using the Blundell and Bond (BB) method presented in panel B. In all 4 models of Table 4
(columns 1 & 2 of panels A &B) the coefficient on the distance (DIST) variable is statistically and economically significant providing
further confirmation that firms do indeed adjust to target levels. We find that the speed of adjustment ranges from 42 to 56%. The
findings imply that adjustment to target levels are statistically significant.
Moreover, to capture the combined impact of Shari’ah compliance along with equity mispricing, we include the interaction terms in
columns 3,4,5 and 6. In line with our expectations, the interaction terms in columns 3 and 4 are positive and significant. Thus, Shari’ah
compliant firms which are above target levels and are faced with equity overvaluation would adjust at more rapid rates relative to their
non-compliant counterparts. This indicates that managers of compliant firms are keener to reduce leverage levels when faced with
favourable environments in the equity market. In addition, it could also imply that non-compliant firms would have lower costs of debt
and thus be less motivated to revert to target levels relative to compliant firms. In addition, the implications further highlight the
motivation for managers of Shari’ah compliant firms to reduce reliance on debt capital in order to create financial slack in order to
preserve financial flexibility to protect future potential growth. Furthermore, the notion of restrictions on raising debt capital form non-
compliant sources creates a further incentive for managers of Shari’ah compliant firms to capture potential gains from increasing
reliance on equity during periods of overvaluation.
In columns 5 and 6 we switch the dummies for the interaction terms to focus on non-compliant firms and firms below target levels to
model the contrary scenario. The Results show that the interaction term is positive and significant showing that for firms below target
levels, non-compliant firms tend to face lower levels of cost of debt and thus have the ability to opt for debt issues during periods of
equity undervaluation. Thus, their reversion to target levels occur at more rapid rates. Conversely, managers of Shari’ah compliant firms
tend to be less inclined to opt for debt issues during periods of equity undervaluation. The findings further support the notion for
managers of Shari’ah compliant firms preserving financial slack as well as having a preference for equities where a reluctance to increase
reliance on debt during periods of suppression of equity prices is evidenced. Another plausible explanation is offered in the literature

Table 4
Measuring speed of adjustment for Shari’ah compliant vs. non-compliant firms based on distance from target leverage & equity mispricing (based on
residual income).
Model (1) (2) (3) (4) (5) (6)

Over-levered firms Under-levered firms

Panel A: Estimating the DISTANCE measure based on FM Method

DISTANCE 0.4204*** 0.5622*** – – – –
(0.0171) (0.0802) – – – –
DISTANCE x SCD x OVERVALD – – 0.7688*** 0.8124*** – –
– – (0.2244) (0.2601) – –
DISTANCE x NSCD x UNDERVALD – – – – 0.4802*** 0.4301***
– – – – (0.0909) (0.1241)
Control variables Yes Yes Yes Yes Yes Yes

Adjusted R2 0.4827 0.5244 0.5011 0.5609 0.5891 0.6204

Wald (p-values) 0 0 0 0 0 0
N 8296 8296 3844 3844 4381 4381
Panel B: Estimating the DISTANCE measure based on BB Method
DISTANCE 0.4644*** 0.6181*** – – – –
(0.0387) (0.1244) – – – –
DISTANCE x SCD x OVERVALD – – 0.6324*** 0.7208*** – –
– – (0.1983) (0.2411) – –
DISTANCE x NSCD x UNDERVALD – – – – 0.4065*** 0.4418***
– – – – (0.1322) (0.1681)
Control variables Yes Yes Yes Yes Yes Yes

Adjusted R2 0.5609 0.6192 0.5822 0.6304 0.6244 0.6692

Wald (p-values) 0.00 0.00 0.00 0.00 0.00 0.00
N 8296 8296 4208 4208 3805 3805

This table presents the estimations of the analysis for adjustment to target leverage. ***, ** and * shows significance at 1%, 5% and 10% respectively.
The dependent variable is the difference of lead and lag leverage (as explained in section 3.3). Book leverage Results are shown in Columns 1, 3 and 5.
Market leverage results are shown in columns 2, 4 and 6. Distance is estimated using the Fama and Macbeth Regressions in Panel A and using the
Blundell and Bond approach in Panel B. SCD is a dummy that is set to 1 if the firm is classified as Shari’ah compliant and 0 otherwise. NSCD is a dummy
that is set to 1 if the firm is classified as non-shari’ah compliant and 0 otherwise. OVERVALD is a dummy that is set to 1 if the firm is classified as
overvalued because its equity price is above the intrinsic estimate and 0 otherwise. UNDERVALD is a dummy that is set to 1 if the firm is classified as
undervalued because its equity price is below the intrinsic estimate and 0 otherwise. Intrinsic estimates are calculated using the residual income
approach as explained in section 3.1. Parenthesis contain 2 – dimension clustered standard errors (clustered at firm and year level. Industry dummies
[0, 1] and year dummies are included in all the regressions. We control for determinants of capital structure speed of adjustment but they are not
reported for brevity.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

where managers of compliant firms tend to have distinctive financing styles (Naz et al., 2017).
Finally, as a robustness test, we define equity mispricing by using another measure which is the analyst forecasts. We collect data on
analyst forecasts from the consensus values available at Bloomberg database. However, due to the unavailability of data on analyst
forecasts for our full sample, we apply this test on a smaller subsample with available data (5802 firm/year observations). We replicate
Table 4 using this new measure of earnings mispricing in Table 5.
Results in Table 5 are robust to our previous Table 4 results. The columns 3 and 4 show that for over-levered firms, Shari’ah
compliant firms tend to benefit the most of equity mispricing and they revert to target levels at faster speeds, while in under-levered
firms (as in columns 5 and 6) non-compliant firms are able to increase leverage levels to adjust to target levels faster during periods
of equity undervaluation. Overall, we find that although firms may be keen to exploit equity mispricing in reaching optimal target levels,
the nature of restrictions from Shari’ah compliance provides further motivation for over-levered firms as well as acts as an inhibitor for
under-levered firms.
The findings provide some insights into the capital structure decisions of firms which face restrictions on debt financing which tend
to motivate distinctive timing attempts by managers. Thus, managers of compliant firms are keen to reduce adjustment costs which
provides the rationale for heightened preference for equities during periods of overvaluation for firms above target levels as well as
limited increased reliance of debt during periods of undervaluation for firms below targets. The findings are of particular importance
given that the sample is from Malaysian capital market, where the literature documents lack of a consensus on explanation of capital
structure in developing markets as well as being able to provide insights given that adjustment costs are known to be high (Haron, 2014).
Furthermore, the dataset utilized is also driven by the nature of screening which is done at institutional level in Malaysia and as of the
end of 2018, 70% of listed firms in Malaysia had acquired compliant status. This provides a unique setting where adjustment costs can be
compared for restrictions based on voluntary adherence to limitations on capital structure. This motivation is justified given that the
capital market in Malaysia remains one of the most developed with regards to Shari’ah compliance (Wilson, 2008). Thus, findings
provide useful insights which allow extension of implications across markets where similar screening methods are applied. In addition,
findings provide rationalisation of earlier studies which document restrictions introduced by such voluntary adherence tends to inhibit
ability to adjust to target levels (Alnori & Alqahtani, 2019). Whilst the findings to do provide some insight into the motivation of
capturing gains from deviation in equity prices, the implications tend to lean towards the original implications of the evidence presented
in Baker and Wurgler (2002) which depict capital markets consisting of rational managers and irrational investors.

Table 5
Measuring speed of adjustment for Shari’ah compliant vs. non-compliant firms based on distance from target leverage & equity mispricing (based on
analysts’ forecasts).
Model (1) (2) (3) (4) (5) (6)

Over-levered firms Under-levered firms

Panel A: Estimating the DISTANCE measures based on FM Method

DISTANCE 0.5601*** 0.6308*** – – – –
(0.0200) (0.0314) – – – –
DISTANCE x SCD x OVERVALD – – 0.6422*** 0.6701*** – –
– – (0.0209) (0.0441) – –
DISTANCE x NSCD x UNDERVALD – – – – 0.5109*** 0.5592***
– – – – (0.1431) (0.1622)
Control variables Yes Yes Yes Yes Yes Yes

Adjusted R2 0.6306 0.6899 0.7298 0.6909 0.5010 0.4653

Wald (p-values) 0.00 0.00 0.00 0.00 0.00 0.00
N 5802 5802 2604 2604 2979 2979
Panel B: Estimating the DISTANCE measure based on BB method
DISTANCE 0.5899*** 0.6910*** – – – –
(0.0328) (0.0501) – – – –
DISTANCE x SCD x OVERVALD – – 0.7244*** 0.7881*** – –
– – (0.0810) (0.1233) – –
DISTANCE x NSCD x UNDERVALD – – – – 0.5891*** 0.6341***
– – – – (0.0905) (0.1466)
Control variables Yes Yes Yes Yes Yes Yes

Adjusted R2 0.5101 0.5722 0.6801 0.7041 0.6451 0.6890

Wald (p-values) 0.00 0.00 0.00 0.00 0.00 0.00
N 5802 5802 2556 2556 3193 3193

This table presents the estimations Results for analysis of adjustment to target leverage similar to Table 4 but when using analysts’ forecasts to estimate
equity mispricing. ***, ** and * shows significance at 1%, 5% and 10% respectively. The dependent variable is the difference of lead and lag leverage
(as explained in section 3.3). Book leverage results are shown in Columns 1, 3 and 5. Market leverage results are shown in columns 2, 4 and 6. Distance
is estimated using the Fama and Macbeth Regressions in Panel A and using the Blundell and Bond approach in Panel B. SCD is a dummy that is set to 1 if
the firm is classified as Shari’ah compliant and 0 otherwise. NSCD is a dummy that is set to 1 if the firm is classified as non-shari’ah compliant and
0 otherwise. OVERVALD is a dummy that is set to 1 if the firm is classified as overvalued based on analysts’ forecasts and 0 otherwise. UNDERVALD is a
dummy that is set to 1 if the firm is classified as undervalued based on analysts’ forecasts and 0 otherwise. Data on analysts’ forecasts is obtained from
Bloomberg for a subsample of 5802 observations. Parenthesis contain 2 – dimension clustered standard errors (clustered at firm and year level. In-
dustry dummies [0, 1] and year dummies are included in all the regressions. We control for determinants of capital structure speed of adjustment but
they are not reported for brevity.

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H.I. Hussain et al. International Review of Economics and Finance xxx (xxxx) xxx

4. Conclusion

The trade-off theory predicts that firms try to meet their target leverage. However, empirical studies find that firms tend to drift away
from target levels due to market imperfections as well as adjustment costs. Therefore, based on the contention evidenced in the liter-
ature, our paper examines the impact of Shari’ah compliance on firms adjustment costs based on the nature of deviation as well as extent
market prices deviation from intrinsic values. In other words, this paper studies the impact of equity mispricing which acts as an
adjustment cost for firms to reach target levels from the perspective of Shari’ah compliance versus non-compliance.
We study a sample of Malaysian firms from 1998 to 2016 to test the impact of equity mispricing and Shari’ah compliance on firms’
adjustment costs to target leverage. Our main research objective is to test the ability and motivation of compliant versus non-compliant
firms in adjusting to target levels in the presence of equity mispricing. Based on our empirical priori, our model is derived from a two-
stage approach in order to appraise the speed of adjustment to target levels which is measured at the lead level (tþ1). To add credence to
our Results, we estimate the target leverage levels in the first stage based on both the static and dynamic view to capture the speed of
adjustment. In the next stage, we capture the rate which firms adjusts to reach target levels by measuring the difference between fitted
values (acting as the target at lead level) and the present leverage level regressed against the net-off between the actual leverage of lead
level and present level of leverage. This approach captures the distance variable which represents the amount in current debt levels the
extent firms must change in order to reach the target debt ratio. Initial results confirm findings documented in previous studies.
However, further testing into the nature of Shari’ah compliance shows that Shari’ah compliant firms adjust at more rapid rates than their
non-compliant firms when over-levered as well as when facing equity overvaluation. In addition, when considering firms below target
levels, non-compliant firms seem to adjust at more rapid rates when faced with equity undervaluation.
Our findings imply that managers of Shari’ah compliant firms which are above target levels are keener to time the equity market in
order to reduce the extent of distance from target levels. Furthermore, Shari’ah compliant firms that could not surpass the target levels
are less likely to increase debt levels even in the presence of equity undervaluation indicating their preference to preserve financial slack.
The findings provide useful insights given that equity mispricing influences timing decisions differently which leads to differing
adjustment costs. The interpretation of Results imply that managers of compliant firms would be focused on timing attempts which if
successful may capture gains for existing shareholders if equity is issued during periods of overvaluation. However, this does indicate
that managers may be unnecassarily allocating time and resources in predicting future price movements in order to anticipate potential
windows of opportunities to raise capital which allows minimal adjustment costs in order to reach target levels and maximize firm value
i.e. shareholders’ wealth. The findings provide several avenues for future research where distinctive preference for sources of financing
can be evaluated. In addition, the need to consider a model which accounts for changes in costs of debt which would also impact target
adjustment behaviour is further warranted. Thus, Shari’ah compliance and equity mispricing work in a dynamic manner and influence
the adjustment costs which firms face in reaching optimal target levels.

CRediT authorship contribution statement

Hafezali Iqbal Hussain: Conceptualization, Writing - original draft. Mohsin Ali: Methodology, Data curation, Writing - review &
editing. M. Kabir Hassan: Supervision, Writing - review & editing. Rwan El-Khatib: Writing - review & editing.

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