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FOREIGN TRADE UNIVERSITY HO CHI MINH CITY CAMPUS *** RESEARCH PROPOSAL Major International Finance THE IMPACT OF FINANCIAL REPORTING QUALITY AND FREE CASH FLOW ON INVESTMENT EFFICIENCY A STUDY IN VIET[.]
FOREIGN TRADE UNIVERSITY HO CHI MINH CITY CAMPUS -*** RESEARCH PROPOSAL Major: International Finance THE IMPACT OF FINANCIAL REPORTING QUALITY AND FREE CASH FLOW ON INVESTMENT EFFICIENCY: A STUDY IN VIETNAM Student name: Phan Anh Duy Student ID: 1913316037 Class: K58CLC2 Year: K58 Supervisor: PhD Nguyễn Thị Hoàng Anh Ho Chi Minh city, February 2023 SUPERVISOR’S REMARK CHAPTER I AN INTRODUCTION TO THE RESEARCH TOPIC Introduction illustrates the background, the issues and the rationales for choosing this topic, research methodology and research structure Research rationale & research background Vietnam has experienced significant economic growth in recent years, making it an attractive destination for foreign investors looking to tap into its potential However, as with any emerging market, there are challenges to doing business in Vietnam, including issues related to financial reporting quality and free cash flow.The efficient management of investment decisions is crucial for the survival and growth of any company, as it directly impacts both current and future income Consequently, investment-related challenges are always at the forefront of concerns for all types of firms, particularly larger corporations Many prominent researchers, including Hoffmire et al (2015) and Gomariz & Ballesta (2014), have identified asymmetric information and agency problems as the two primary factors that affect investment efficiency The lack of transparency in financial reporting quality poses a significant barrier for investors in the Vietnamese market, despite its attractiveness to both domestic and foreign funds, as demonstrated by Korea’s $49 billion registered capital at the end of May 2016 In a capital-market-driven economy, investors play sụch a vital role, but this also creates an opportunity for managers to act in their self-interest via asymmetric information & agency problems, leading to overinvestment or underinvestment decisions Financial information is crucial for investors to make sound economic decisions In an imperfect market, information disparity between shareholders and managers results from inadequate supervision, which ultimately favors the managers Based on research by Healy and Palepu (2001), enhancing FRQ is also the solve the question of how to diminish misconstrue investment Moreover, based on research conducted by Kanodia and Lee (1998), financial reporting quality can help lessen agency problems Another determinant affects investment efficiency is the free cash flow When the supervisors are able to maintain high levels of cash flow, although the corporation is able to scale up their business, the likelihood of inefficient investment is also increased As reported by Stulz et al (2001) and Harford (1999) suggested that companies with ample cash reserves are more likely to engage in overinvestment Financial reports are used to display a company's activities, but unfortunately, some companies manipulate their financial statements to deceive investors by concealing losses This leads to an unfair business environment and results in significant harm to investors Invesment in projects that does not generate much benefits for the company is major compelling reason In Vietnam, many companies have published dishonest financial reports, such as Vinashin's scandalous problems, where false financial data was presented to attract investment despite facing significant debts Additionally, managers easily embezzle substantial amounts of assets Therefore, improving the quality of financial reporting is crucial for Vietnam's economy Moreover, research has been conducted in a number of developed countries regarding the between the impact of financial reporting quality & free cash flow on investment efficiency However, there hardly any studies regarding this topic in developing countries, where there are tons of different business models with different flow of money Therefore, investigating new markets like the Vietnamese market is in needs Previous research has shown that financial reporting quality and free cash flow are both significant factors that influence investment efficiency For instance, Biddle et al (2009) found that the performance of the firms indicate how efficiency their investment efficiency depends on economic activities of each firm, and the absolute residual of the investment model is used to calculate investment efficiency Additionally, Sial et al (2017) conducted a study on Pakistani listed firms and found that free cash flow has a positive impact on investment efficiency This is in line with the findings of other studies, such as those conducted by Sial, Akbar, and Azam (2017) and Chen et al (2016) Another example is the research by Salehi and Amiri (2012) on firms listed in the Tehran Stock Exchange Their study revealed that financial reporting quality and free cash flow were both positively associated with investment efficiency In addition, they found that firm size, tangibility, and Altman’s Z score were significant control variables in the model Furthermore, the study by Hoffmire et al (2015) on US firms found that financial reporting quality was positively related to investment efficiency, while free cash flow had a negative impact on it Their research also revealed that firms with a longer operating cycle had better investment efficiency Objectives and research questions 2.1 Research hypothesis The main objective of this study is to investigate the correlation between the quality of the financial reporting quality and investment efficiency in various sectors of the Vietnamese market Additionally, the research will also examine several determinants of investment named the size of firms, financial leverage, free cash flow, and revenue growth rate In particular, free cash flow is a new factor that is expected to impact this relationship The study aims to answer the influence of financial reporting quality on investment efficiency and how the free cash flow moderate the relationship between financial reporting quality and investment efficiency: H1: There is a negative correlation between the quality of financial reporting and overinvestment H2: There is a negative correlation between the quality of financial reporting and underinvestment H3: The negative relationship between financial reporting quality and overinvestment is more prominent for businesses that possess substantial free cash flows H4: The negative relationship between financial reporting quality and underinvestment is more prominent for businesses that possess substantial free cash flows 2.2 Scale and scope of the research To conduct each test, reliable secondary data was gathered from the annual financial reports of 200 firms listed on HOSE, obtained from trustworthy sources over the course of years, starting from 2017 The dependable data sources include finance.vietstock.vn, FiinPro Research methodology 3.1 Research subjects The thesis focus on investigating the following subjects regarding the financial reporting quality, the free cash flow and the investment efficiency 3.2 Methodology The methodology employed in this research is quantitative in nature The research includes data gathered from reliable sources including FiinPro - one of the most prestigious in-depth financial data providers, on financial reports of 200 Vietnamese corporations that are listed on Hochiminh Stock Exchange (HOSE) Despite the existence of two official stock exchanges in Vietnam, namely the Hanoi Stock Exchange (HNX) and the Hochiminh Stock Exchange (HoSE), the data for this study was obtained from firms listed on the Hochiminh Stock Exchange due to its transparency The study adopted a longitudinal approach using panel data, given that the data was collected between 2019 to 2021, allowing for the analysis of consecutive years of data for each firm The collected data was analyzed using the linear regression function in the Stata software The thesis conducts research on financial reporting quality, degrees of free cash flow and efficiency between investment decisions; Since then, the thesis concentrates on investigating the relationship between financial reporting quality factors, free cash flow and investment performance of listed companies on HOSE To perform this thesis, panel data is applied to due a number of rationales Since the data requires vigorous space and timetime, with data range from 2017 to 2022 of roughly 200 companies, panel data seems to be the most suitable method Furthermore, the issue regarding heterogeneity among companies and especially the multicollinearity amidst variables could be solved using techniques including in this method In the analysis of regression models using panel data, there are three prevalent categories: pooled models, fixed effect models (namely as FEM), and random effects models (namely as REM) Each model exhibits distinct traits and notable features, making it crucial to accurately distinguish and identify them to attain precise outcomes These models consist of three types of variables: dependent variables (Investment), independent variables (financial reporting quality, free cash flow), and controlling variables (Financial solvency, size, age, Tobin’s Q, tangibility, Length of operating cycle, other controlling variables) to make the regression results robust To obtain precise estimations, a comprehensive examination of all hypotheses tested is necessary To access whether to implement the FEM or REM would result in a more appropriate for the model, Hausman test is conducted With the selection between FEM and pooled model, the testing namely as redundant fixed affect test should be applied Moreover, due to sufficient data included in the model, the F test and t test are selected to examine whether they vary from As reported by Hinkle (2003), to handle the issue regarding multicollinearity, there had been a significant problem regarding collinearity, leading to the difficulty to measure the regression coefficients Research structure Chapter I of this study includes an introduction that provides background information on the topic, outlines the main problem, reasons for choosing the topic, research approach, and research structure Chapter II consists of a literature review that covers the definition, theory, and related empirical studies on investment efficiency, financial reporting quality, and free cash flow Chapter III details the research design, data collection method, and explains the empirical regression methods used and the hypothesis testing in panel data, and it also describes the proxies and variables in the models Chapter IV, the results of the regression are analyzed and discussed Chapter V presents the limitations, conclusions, and recommendations of the study, along with suggestions for future research CHAPTER II INVESTMENT EFFICIENCY, FINANCIAL REPORTING QUALITY & FREE CASH FLOW: CONCEPTS, RELATED THEORIES & LITERATURE REVIEW The following chapter demonstrates the literature review regarding the definition and related empirical studies of financial reporting quality, investment efficiency & free cash flow Literature review 5.1 Definition of asymmetric information and agency problems Speaking about governance or corporate administration, the sovereign objective of the company head is to attain the sustainable growth over time But, the first and foremost worry that bother the investors is the asymmetric information and the agency problems, which leading to several loss to investors Therefore, it is crucial for firms to minimize the mentioned issues to maximize the development of the company In according with Jensen and Meckling (1976), they have stated that managers, who in charge of the business, may have a driving force to benefit themselves by manipulating the data to compose the financial reports This can have large impact on the investment decisions of owners For instances, on the side of creditors, creditors always want businesses to invest in projects with low risk, bringing stable cash flow so that they can fully fulfill their obligations to pay principal and interest For business operators, conflicts of interest will cause them to make wrong investment decisions with the aim of maximizing the owner's interests First, the business operator, for his own benefit, can choose non-optimal projects with low returns; low-risk and unconcerned with shareholders' preference for riskier projects This can be explained by the fact that the income level of business executives largely depends on the development status of the business Therefore, when they have to choose between two projects, they tend to invest in the low-risk project with a higher probability of success Then, temporary growth helps executives increase current income levels despite the interests of shareholders and creditors The above-mentioned wrong investment decisions of the managers only benefit a few entities and harm the rest 5.2 Definition of investment efficiency Determinants of investment efficiency are the compound of the profit and the risks involved Inefficiency investment decisions could be the result of conflicts among the managers, the creditors and the shareholders To measure the investment efficiency, the approach can be seperated into overinvestment and underinvestment Based on research conducted by Jensen (1986), those firms with superfluous cash indicate the projects that the managers had invested in are not effective, but more about personal benefits Hence, no value was add-in to the value of the company Conflicts among investors and creditors could also derive the underinvestment, most foreseeable case are the business that utilize debt to finance their investments The investors might interested in risky projects with highly return, as receive dividends in short term In short, these projects provide more advantages to creditors compared to shareholders Therefore, there would be no investment in new projects, which can harm the growth of the firms, as reported by Myers (1977) 5.2.1 Overinvestment definition Overinvestment is a situation where a company invests too much in projects or assets, resulting in a decrease in the firm's value It occurs when a company has access to excess capital and cannot identify sufficient profitable investment opportunities One article that relates to the topic and discusses overinvestment is "Investment inefficiency and overinvestment: Evidence from Chinese firms" by Kuan Xu and Yan Wang (2018) The authors investigate the relationship between overinvestment and investment efficiency for Chinese firms and find that overinvestment leads to lower investment efficiency They also suggest that external financing constraints can exacerbate the negative effects of overinvestment on investment efficiency 5.2.2 Underinvestment definition Underinvestment refers to a situation where a firm invests less than what is required for the optimal level of investments based on the available opportunities This can occur due to a variety of reasons such as financial constraints, lack of access to capital, managerial preferences, or uncertainty about future market conditions An article published by T V., Nguyen, H T T., etc (2020), investigates the impact of free cash flow and financial reporting quality on underinvestment in Vietnamese listed firms The authors argue that underinvestment occurs when firms not invest enough in profitable projects, leading to reduced future growth opportunities and lower profitability They find that both free cash flow and financial reporting quality have significant negative impacts on underinvestment, indicating that firms with higher levels of free cash flow and better financial reporting quality are less likely to underinvest The study highlights the importance of managing free cash flow and maintaining high levels of financial reporting quality to avoid underinvestment and promote sustainable growth for Vietnamese listed firms 5.3 Definition of financial reporting quality & free cash flow Financial reporting quality refers to the degree of accuracy, transparency, and completeness in financial reporting High-quality financial reporting provides reliable information that can be used to make informed decisions about investment opportunities The impact of financial reporting quality on investment efficiency is a crucial topic, and many researchers have studied this area One key factor that impacts investment efficiency is free cash flow (FCF), which is the cash generated after deducting business expenses from income In a perfect market with no asymmetric information or moral hazard, there is no relationship between financial reporting quality and FCF However, in the imperfect market, the existence of asymmetric information and agency problems can make it difficult for firms to get funds from external capital markets Therefore, financial