Abstract
This study looks at how firms react to shocks in equity prices based on a classification which arises from social pressures rather than the financial objective of maximizing shareholders’ wealth. In order to meet the objective of the study, a sample of Malaysian firms from the period of 2003 to 2018 was utilized to evaluate the relationship between market and book debt ratios based on a social distinction. The study is based on the theoretical expectation that managers are inclined to adjust book debt ratios to converge with market debt values which arise from changes in equity values over time. We introduce a unique institutional setting into the relationship which is readily observable in the Malaysian capital market given the existence of Shari’ah and non-Shari’ah compliant company classifications on the stock exchange (Bursa Malaysia), as screened by the Securities Commission. The classification forms the basis for distinguishing Socially Responsible Investment options for investors. The findings reveal the existence of asymmetries in how both categories of firms adjust towards shocks in equity prices. The findings document that both compliant and non-compliant firms decrease book debt ratios in line with increases in firms’ equity values. Compliant firms, on the other hand, are more likely to increase book debt ratios during periods of decreases in equity values. Non-compliant firms do not significantly alter book debt ratios during periods of declining equity prices. The findings indicate that whilst firms tend to decrease debt levels in the presence of future growth potential, the response is asymmetric during periods of suppression of share prices. Thus, the screening of compliant versus non-compliant firms allows investors to distinguish sustainable firms in the long run, which further allows diversification when holding socially responsible investment portfolios. Our conclusions have wide reaching implications on a global scale for the development of sustainable capital markets.
Highlights
The area of capital structure has received widespread attention in the literature of corporate finance
The plots indicate that market leverage ratios are only greater than book ratios during the period of recession given the decline in equity prices which mirrors findings in the literature [27]
The plots indicate that market leverage ratios are only greater than book ratios during the period of recession given the decline in equity prices which mirrors findings in the literatu0re.0[427] The mean difference is more evident for non-Shari’ah compliant firms, w0.h02ich tends to indicate these categories of firms tend to face greater levels of volatility in
Summary
The area of capital structure has received widespread attention in the literature of corporate finance. There has been some consensus in the literature that both measures of debt levels; namely the book and market leverage are inter-related, and are of concern to managers [1]. Given that equity values tend to change due to fluctuations in share prices and returns, there would be a gap between both measures. The literature documents that firms do not necessarily respond to shocks in equity prices by changing the book values of their debt as it would lead to an observable deviation during differing periods of rises and falls in share prices [2]. The current study proposes to offer a distinctive perspective on the relationship between market and book leverage ratios by examining the impact of Shari’ah compliance on the divergence between both values. The notion is based on the differing styles of the managers of both categories of firms, as well as the potential for differing preferences for debt policy [3]
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