Growth Opportunities Utilization: Debt Overhang or Asymmetric Information?

The conflict between managers, shareholders, and debtholders is caused by differences in the interests of in-place financing assets to take advantage of growth opportunities based on the ability to generate profitable investments. With information asymmetry and incomplete nexus contracts, this conflict could lead managers to act based on two interests: their interest as a debtholder or as a shareholder (Cariola, et al., 2011; La Rocca, et al., 2007). Suppose they act based on their interests as a debtholder. In that case, the investment decision could be detrimental to shareholders' interests because debtholders are prone to making riskless investments despite low returns. On the other hand, investments made in shareholders' interests through suboptimal investments, oriented to maximizing equity value and not corporate value, could also be detrimental to debtholders. In turn, this could elicit conflict between senior new shareholders.

The underinvestment problem is related to debt overhang (Myers, 1977). Companies with high leverage and managers who act in the interests of shareholders will reject positive NPV projects. For debtors, debt becomes riskier (risky debt) because of the increased risk of financial difficulties and company bankruptcy. Ultimately, the debt does not pay off. On the other hand, the manager will not choose the project because it only benefits debtholders without additional benefits to shareholders. This situation results in a conflict of interest for shareholders and debtholders due to a debt overhang. Debt is a “tax” because the company must firstly pay the principal and loan interest to debtholders, while shareholders only receive its residual (Stein, 2001). Even though the project has a positive NPV, as long as it does not provide significant benefits to shareholders, the manager would refuse (underinvestment), thus becoming a risky debt for debtholders. When the company is independent and has an overhang, the impact on reducing investment incentives is that opportunities to exploit growth are limited (Mondosha and Majoni, 2018). When assets in place are financed by debt, it influences the decision to take advantage of and create growth opportunities. Because in this way, it puts pressure on the quality of investment decisions, which is based not only on cash flow, but also on the project's ability to provide more residuals to shareholders (Cariola, et al., 2011). This situation results in the indebted company losing the opportunity to grow because it refuses all projects that only benefit debtholders.

Specifically, investment choices are related to growth opportunities and financial conditions (Brito and John, 2005; Cariola, et al., 2011). First, when growth opportunities are high and financial conditions are good, the optimal investment will occur. Second, when growth opportunities are low and financial conditions are poor (high leverage), debt overhang or underinvestment occurs (Myers, 1977). Third, when growth opportunities are high and financial conditions are bad (leverage is high), risk avoidance occurs (Brito and John, 2005). Conversely, when growth opportunities are low and financial conditions are poor (high leverage), risk shifting occurs (Jensen and Meckling, 1976). So, this high-leverage situation generates various possibilities for the discretion of managers who side with the interests of shareholders, who explore the use of growth opportunities.

Manager agency problems’ discretion in allocating investment resources has an impact on asymmetric information (Degryse and Jong, 2001). The presence of untapped growth opportunities creates agency costs of risky debt, such as risk avoidance, risk shifting, and underinvestment. This agency problem produces information asymmetry between shareholders (managers) and debtholders. When debtholders cannot determine the quality of information regarding shareholders' investment decisions (asymmetric information), it will increase the agency cost of debt. It will limit lending and increase the interest rates. The presence of new shares results in a dilution, reducing the power of the past stakeholders. As an implication, conflicts between new and old shareholders arise (Cariola, et al., 2011).

The information asymmetry problem is generated because debtholders prevent managers' opportunistic behavior from acting on shareholders' interests. Such cases are found in specific firm forms, such as age and size (Degryse and Jong, 2001). Information from older companies is more exposed than from younger firms (Tayem, 2018), lowering the level of asymmetric information. In addition to firm age, asymmetric information is generated from firm size. Large companies tend to have fewer information asymmetry problems, whereas small companies with high growth have higher information asymmetry (Frank and Goyal, 2003; Tayem, 2018). Having better governance and financial analysts and gaining public attention cause larger companies to have lower information asymmetry levels (Hwang, et al., 2019). In other words, older and larger companies have less asymmetric information, allowing them to obtain equity funding when a debt overhang occurs. At the same time, companies can continue to take advantage of growth opportunities other than debt.

This paper divides the explanation of industries' leverage variation based on two causes: agency problems and asymmetric information. First, the global crisis of 1997–1998 and the bailout in Europe in 2008 significantly impacted Indonesia. They provided lessons for private sectors about the need to reduce the debt ratio in anticipation of increased risk (Nursechafia and Muthohharoh, 2014). The crisis was caused by the weak implementation of corporate governance with family control, business group affiliation, cash flow control, and political connections (Harijono and Tanewski, 2012). All companies across industries have excessive debt ratios, so the impact of the crisis is across industries. As a result, shareholders do not receive any residual because the bankruptcy effect leaves debtors to fulfill obligations.

In this research, the influence of the 1998 Indonesian crisis is not considered because it is no longer relevant to the present situation. The current situation is more accurately described as a pre-crisis form. The differences in risk cause differences in the inter-industry leverage. However, the intra-industry leverage level is relatively similar due to its business and risk homogeneity that tends to stabilize over time (Das and Roy, 2007). Das and Roy (2007) explained that leverage between industries tends to vary, depending on industry characteristics. In industries with low growth and high leverage, managers' decisions limit investment. Companies in the same industry have relatively no different capital structures (e.g., computer software, oilfield services, pharmaceutical). However, in other industries, the capital structure is entirely different (e.g., aluminum, food wholesale, drugstores) (Almazan and Molina, 2005). More specifically, companies with more leverage than the target will reduce investment capital expenditures, which does not happen to under-leveraged companies. Thus, inter-industry leverage varies depending on the agency problem that results from inherent leverage.

Second, the difference in leverage between industries is the asymmetric information produced by variations in the inter-industry companies' size and age. Some literature finds that firm size is inversely related to information asymmetry (Degryse and Jong, 2001). They specifically explained that greater information asymmetry is found in smaller firms because of the high cost of obtaining information. Additionally, fixed assets are easier to value than non-fixed assets. Hence, companies with more considerable fixed assets can use them as collateral to limit financial constraints. The three company track records are visible from age. Older companies have lower information asymmetry by providing information that is easily accessible to the public. Also, inter-industry has different characteristics from the debtors' perspective, such as the need for assets and the business cycle (Leclerc, 2016).

Furthermore, large-sized companies have more funding options compared to small-sized companies. Age, measured since going public, impacts funding sources' heterogeneity (Almazan and Molina, 2005). Large companies have better governance and better disclosure, so that information asymmetry is lower - this difference in information asymmetry results in the differences in independent companies' opportunity to grow.

This study employs industry measurements – variations in mean leverage between industries – (Graham and Leary, 2011). This choice is made because of the assumption that the mean leverage between industries is not different (Das and Roy, 2007). Also, time series data is used to determine variations in leverage as a proxy agency problem and information asymmetry. The increase in leverage time series shows the potential for a debt overhang to occur, producing conflict between shareholders and debtholders. Additionally, ex-ante information asymmetry results in a decrease in leverage.

Managers’ discretion in increasing firm value depends on choosing a profitable investment based on future growth opportunities (Myers, 1977). With discretionary power, they can make decisions based on shareholders' interests, potentially causing conflicts with debtholders, such as underinvestment (Cariola, et al., 2011; Jensen and Meckling, 1976).

When managers make decisions to increase firm value, they select all projects with a positive NPV, but high debt prompts them to act entirely differently. The presence of high debt as risky debt results in their decision to reject a project with a positive NPV because, if the investment is successful, it will only benefit the debtholder, namely debt market value exceeds the nominal value without generating benefits for shareholders (Cariola, et al., 2011; Myers, 1977). If the investment fails, they must still pay debts and principal loans to debtholders, such as the tax on profit from the investment made (Stein, 2001).

Underinvestment due to agency problems and ex-ante information asymmetry causes debtholders to make adverse choices, preventing managers’ and shareholders' opportunistic behavior by limiting credit or increasing loan interest rates. The uncertainty regarding the quality of investment information has resulted in risky debt and increased debt costs for debtholders. This condition encourages various actions from the managers. First, a risky debt would drive managers to reject projects with positive NPV, which could cause them to lose growth opportunities. Thus, higher leverage increases the chance for projects with positive NPV to be rejected. The underinvestment hypothesis explains that risky debt decreases debt from the total resources meant for new investments.

Hypothesis 1: The number of resources for new investments is lower than planned, limiting companies from taking growth opportunities and creating economic value.

The second hypothesis related to risk is risk shifting; leverage positively affects growth opportunities (Jensen and Meckling, 1976). They explained that shareholders would invest when the level of risk is above average. The fact is that companies do risk shifting when there is an increase in leverage, so there is an increase in the risk of bankruptcy and financial difficulties. On the contrary, risk avoidance, namely the increase in leverage, does not significantly impact investment in growth opportunities (Brito and John, 2005). Managers tend to make investment decisions that do not exceed the average risk for peers, in order to protect their control over the company. This situation can ultimately lower future growth opportunities.

The demand for the premium cost of debt can be reduced by the presence of a debt covenant, which can control the conflict between shareholders and debtors over the implementation of growth options to use low debt (Billett, et al., 2007). Apart from the Anglo and American models, debt covenants are different in large developing economies such as China, India, Brazil, and second-tier developing economies such as Indonesia and South Africa and new market economies such as Russia (Taylor, 2013). In Indonesia, debt covenants' implementation has not reduced debtholders’ and share methods' conflicts, so there is still high interest for indebted companies (Rossieta, 2009). So, in the absence of a debt covenant, information asymmetry results in debtholder precautions against managers and shareholders through increased interest rates.

Consequently, companies choose to invest in lower debt options, even though it offers high growth opportunities (Ari, 2017; Billett, et al., 2007). Growth opportunities are not utilized in debt overhang companies with a high level of asymmetry.

Hypothesis 2: Large and older companies have a lower level of asymmetry, which allows them to have equity funding when a debt overhang occurs.

The skewness data showed that industry A, TSI, and WI had a leverage level below the median. Aside from all three industries mentioned above, all the remaining industries had a leverage level above the median. Thus, there was a difference in the leverage level of industry A, TSI, and WI with the remaining sectors. This result in Table 2 indicates that differences in risk and firm characteristics could result in differences in leverage.

The research found 16.9% variations in leverage due to differences between inter industries (RMSSE value in Table 3). Leverage firms had a greater variation than unleveraged firms due to the free cash flow hypothesis (Jensen and Meckling, 1976). The free cash flow argument explains that a different growth rate characterizes each industry, so that leverage also varies (Das and Roy, 2007). We present the Fig. 1 in time series data for 2009–2019. The mean leverage in inter-industry is relatively stable, indicating that managers acting in shareholders' interests prevent conflicts with debtholders and encourage avoidance of debt overhang.

Figure 1

In 2009, the mean leverage was the most varied, while low variation was evident in 2013, indicating the need for leverage in response to growth differences. Companies in inter-industry tend to take time series to try to prevent agency conflicts (Almazan and Molina, 2005).

Furthermore, the difference in firm age and firm size intra-industry determined by ANOVA is reported in Table 4.

Companies in inter-industry had a mean age below the median age, and with a negative kurtosis, it was relatively heterogeneous as depicted in Table 5. The mean age variation was more significant in the CGI and MI industries than in other industries.

The research found 2.3% variations in age due to differences between inter industries (RMSSE value in Table 6), and was below the median (positive skewness), and that inter-industry had mean age heterogeneity (negative kurtosis).

Table 7 show negative skewness was found when most companies in industries A, CGI, M, and PRB had total assets above the median, while others had them below the median. Industry A and MI had a positive kurtosis, so the total assets' variation was lower than those owned by other sectors.

The findings found 3.9% variations in size due to differences between inter industries (RMSSE value in Table 8), The variation in total assets was greater in the CGI because it grew larger than others in the observation period.

The findings show that (1) there is a low correlation between the independent variables and (2) there are differences in leverage, age, and sizes between industries. The findings of the independence of the independent variables and inter-industry differences are predicted not to produce a growth opportunity bias, allowing regression testing to be carried out.

Several cross-country studies have shown firm age and firm size are the factors that make information asymmetry. A research by Das and Roy (2007) examined cross-sectional data in India and the result showed that there were differences in the inter-industry debt ratio between the pre- (1979–1980) and post-liberalization periods (1998–1999). The difference is due to the size of the company and the varied inter-industry needs, where technology-based industries have a larger debt ratio than the other. Although it appears that after liberalization, larger firms were given better access to banking and capital markets than preliberalization, this policy is inconsistent. In more detail, Aminadav and Papaioannou (2016) explain that companies in India have a concentrated ownership structure within 30%.

During the non-tradable shares (NTS) reform period in China, Qu, et al. (2018) found that varying information asymmetry resulted in differences in debt ratios across industries. The presence of information asymmetry causes good-quality companies to issue debt the same way as bad-quality companies. As a result, debt issued by good-quality companies is under-valued and bad-quality companies are overvalued. Qu, et al. (2018) explained, the NTS period 2007–2007 within 72% is State-Owned Enterprises (SOE) or other government agencies, where the government has approximately 20% share ownership. As a result, the government's backing to SOE increases debt because the government is oriented toward political, social, and tax revenue motivation factors for SOE.

A study by Maria, et al. (2019) conducted in 15 European Union countries by adding industry and country variables in dummy regression reported differences in capital structure across the industry. The level of information asymmetry in each life cycle stage, which varies, results in different financing decisions. More young firms have less information asymmetry than old firms; as a result, older firms can access more non-bank funding sources than younger firms.

The concentrated ownership structure produces agency problems between managers with investor (shareholders with debtholders). Akerlof (1970) describes a used car market that sells plums and lemons, resulting in adverse selection problems and moral hazards. When managers act to serve the interests of shareholders faced with investment choices, they will issue equity when overvalued and will pass up investment projects when undervalued. Thus, the issuance of equity conveys negative information to the market. Therefore, when there is information asymmetry, the company uses internal funds first, then risky debt and, in turn, equity, as explained by Pecking Order Theory (POT).

The previous paper proved that firm age and firm size produce asymmetric information, so that companies follow the POT hierarchy, which prefers debt over equity. However, when companies use more leverage, it will have an impact on exploiting future growth opportunities. There are two possible outcomes: first, debt overhang, where the company will pass up future growth opportunities with a positive NPV because it only increases the welfare of debtholders and second, overinvestment, where companies take advantage of future growth opportunities with negative NPV because with the limited liability of shareholders, this situation results in losses for debtholders. Next, we report the regression results to find out information asymmetry on the utilization of growth opportunities.

Firm value is generated from financed assets in exploiting growth opportunities through profitable investment (Myers, 1977). The managers of independent companies have discretion in making investment decisions based on shareholders' interests, causing them to reject investments with positive NPV (underinvestment). Debt overhang causes companies to lose growth, turning it into a risk for debtholders. The situation above encourages agency conflicts between shareholders and debtholders, impacting the companies' inability to pay debts. The increased risk of companies being unable to pay the debt causes debtholders to raise interest rates and limit lending, forcing shareholders to seek cheaper external funding sources (i.e., capital market). In-place asset financing or inter-industry DAR ranges from 22.7% to 61.6%. Thus, the company keeps the debt from becoming overhang from time to time. Managers often decide to underinvest or conduct risk shifting when a debt overhang occurs, causing a decrease in growing sales. However, leverage does not affect sales growth (model 2). As a result, there is no underinvestment or risk shifting.

In East Asia, including Indonesia, ownership structure does not separate ownership and control, allowing managers to always act in shareholders' interests (Claessens, et al., 2000). The ownership structure of companies in Indonesia tends to be concentrated, with 65.14% controlled by the majority shareholders and 66.45% owned by individuals or groups or families (Rusmin, et al., 2011). They added that, in some cases, family members are also placed as independent commissioners to maintain family control over the company. To maintain control and prevent this conflict, family companies will identify their members as debtholders (Villalonga, et al., 2015)

Shareholders have an interest in maintaining the family company or controlling shareholders. Thus, in older companies, the ownership structure tends to be concentrated. Shareholders do not want to lose ownership to long-running companies, so they maintain the debt level not to cause debt overhang. This condition triggers shareholders to avoid risky debt, so that the interest of the debtholders is maintained. As such, the relationship between debtholders and shareholders can be in line with one another. Companies in Indonesia are primarily family owned and are more oriented toward ensuring long-term goals, safeguarding family reputation, and maintaining togetherness by not diversifying the ownership (Anderson, et al., 2005).

The existence of agency problems between shareholders and bondholders results in asymmetric information. Bondholders do not know the quality of investment information because of the opportunistic managers and shareholders. The results, bondholders limiting lending and increasing the interest rate. No agency problem is evident, but information asymmetry is an issue that negatively affects growth sales.

Model 2 shows that older firms have fewer information asymmetry problems.

The age measured since going public impacts the heterogeneity of funding sources (Almazan and Molina, 2005). Table 9 represent companies growth sales, As an implication, companies have sources of funding other than debt. Agency problems do not coincide with asymmetric information, in contrast to the initial hypothesis that explains the relationship (Cariola, et al., 2011; La Rocca, et al., 2007).

Older companies have less asymmetric information because they provide better information compared to smaller companies. Thus, the public becomes more aware of older companies' information than that of younger companies (Tayem, 2018). As a result, when there is no debt overhang due to risky debt, older companies tend to lower growth opportunities. An older company without agency conflict and asymmetric information has higher retention of control. Shareholders can obtain external funds more quickly because there is no information asymmetry problem, but they still use debt and experience debt overhangs. Older companies concentrate more on ownership (Claessens, et al., 2000) and still prioritize debt as a funding source. They are afraid of losing their company during a debt overhang, resulting in asset takeover by debtholders. Martinez, et al. (2019) provide similar evidence, when the age of a company that produces asymmetric information. The older firms, and with smaller asymmetry information results in a decrease in the utilization of growth opportunities.

The impact is the use of growth opportunities through debt restriction, although it can increase debt because there is no information asymmetry. Without agency conflict, the information asymmetry caused by the firm size only increases by 1%, so it has a significant probability of increasing the growth opportunity by 0.1%.

Thus, information asymmetry does not result in a debt overhang, so that the company loses growth opportunities. The agency problem explains the conflict between managers and shareholders with debtholders. The presence of debt can stimulate opportunistic managerial behavior to reject growth opportunities with positive NPV because it only benefits debtholders. The use of growth opportunities is not determined by debt and size, but rather by firm age. Company size is a total asset that contains information asymmetry (Lang, et al., 1996), so that it has the potential to result in undervalued issued debt. Likewise, more debt issues result in control and monitoring of debtholders, so that companies do not issue debt to finance growth opportunities.

On the other hand, when firms are older and have a lower level of information asymmetry (Month and Yan, 2012; La Rocca, et al., 2011), they prefer equity over debt. Because it stimulates capital market evaluation due to equity issuance, managers who act to serve shareholders will prevent the decline stage by exploiting growth opportunities.