Asymmetric capital structure speed of adjustment, equity mispricing and Shari’ah compliance of Malaysian firms

Traditionally, equity mispricing has been documented as an important determinant of speed of adjustment to target leverage levels. More recently, the impact of Shari’ah compliance has been shown to significantly affect capital structure decisions. In this paper, we explore the effect of equity mispricing in Shari’ah compliant (vs. non-compliant) firms. We conduct our study on a comprehensive sample of Malaysian firms from year 1998–2016. We show that established findings in the dynamic trade-off theory do not hold for Shari’ah compliant firms. Shari’ah compliant firms increase their reliance on equity financing at greater levels than non-compliant firms when they are above target levels and equities are overpriced. In contrast, for Shari’ah compliant firms below target levels and where equity is under-priced, the rate of adjustment is slower than non-compliant firms. Our findings suggest that managers of Shari’ah compliant 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.