Optimal capital structure: A dynamic approach in the Indonesian capital market

This study analyzed the effect of profitability on leverage through the dynamic inaction model. This model implies that the effect of profitability on leverage may vary, depending on firms' capital structure optimality, which is achieved through refinancing activity. By using panel data regression and the generalized method of moments (GMM), the study investigated the dynamic effect of profitability on the leverage of 175 publicly listed firms on the Indonesia Stock Exchange during the period 2006-2015. It was found that profitability had no significant effect on leverage, both in firms with optimal and nonoptimal capital structures. However, when capital structure was optimal, firm and industry characteristics had better abilities to explain leverage. Profitability also had no significant effect on predicting refinancing activity; however, firm size had better predictive power. In adjusting their capital structures to an optimal target, larger sized firms and those with higher profitability tended to adjust their leverage faster, while those with higher growth opportunities and bigger leverage gaps tended to do this more slowly. The study revealed that in Indonesia, firms with optimal capital structures might have different leveragedeterminant factors from those with non-optimal capital structures.