The Impact Of Financial Reporting Quality And Free Cash Flow On Investment Efficiency A Study In Vietnam.docx

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

1 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 efficientmanagement of investment decisions is crucial for the survival and growth of anycompany, as it directly impacts both current and future income Consequently,investment-related challenges are always at the forefront of concerns for all types offirms, particularly larger corporations Many prominent researchers, including Hoffmire

et al (2015) and Gomariz & Ballesta (2014), have identified asymmetric information andagency problems as the two primary factors that affect investment efficiency

The lack of transparency in financial reporting quality poses a significant barrierfor investors in the Vietnamese market, despite its attractiveness to both domestic andforeign funds, as demonstrated by Korea’s $49 billion registered capital at the end ofMay 2016 In a capital-market-driven economy, investors play sụch a vital role, but thisalso creates an opportunity for managers to act in their self-interest via asymmetricinformation & 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 resultsfrom inadequate supervision, which ultimately favors the managers Based on research byHealy and Palepu (2001), enhancing FRQ is also the solve the question of how to

diminish misconstrue investment Moreover, based on research conducted by Kanodiaand Lee (1998), financial reporting quality can help lessen agency problems.

Another determinant affects investment efficiency is the free cash flow When thesupervisors 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 Asreported by Stulz et al (2001) and Harford (1999) suggested that companies with amplecash 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 concealinglosses This leads to an unfair business environment and results in significant harm toinvestors Invesment in projects that does not generate much benefits for the company ismajor compelling reason In Vietnam, many companies have published dishonestfinancial reports, such as Vinashin's scandalous problems, where false financial data waspresented to attract investment despite facing significant debts Additionally, managerseasily embezzle substantial amounts of assets Therefore, improving the quality offinancial reporting is crucial for Vietnam's economy Moreover, research has beenconducted in a number of developed countries regarding the between the impact offinancial reporting quality & free cash flow on investment efficiency However, therehardly any studies regarding this topic in developing countries, where there are tons ofdifferent business models with different flow of money Therefore, investigating newmarkets like the Vietnamese market is in needs

Previous research has shown that financial reporting quality and free cash flow areboth significant factors that influence investment efficiency For instance, Biddle et al.(2009) found that the performance of the firms indicate how efficiency their investmentefficiency depends on economic activities of each firm, and the absolute residual of theinvestment 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 apositive 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 TehranStock Exchange Their study revealed that financial reporting quality and free cash flowwere both positively associated with investment efficiency In addition, they found thatfirm size, tangibility, and Altman’s Z score were significant control variables in themodel Furthermore, the study by Hoffmire et al (2015) on US firms found that financialreporting 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 operatingcycle had better investment efficiency

2 Objectives and research questions

2.1 Research hypothesis

The main objective of this study is to investigate the correlation between thequality of the financial reporting quality and investment efficiency in various sectors ofthe Vietnamese market Additionally, the research will also examine several determinants

of investment named the size of firms, financial leverage, free cash flow, and revenuegrowth rate In particular, free cash flow is a new factor that is expected to impact thisrelationship The study aims to answer the influence of financial reporting quality oninvestment efficiency and how the free cash flow moderate the relationship betweenfinancial 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 thecourse of 5 years, starting from 2017 The dependable data sources include

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 fromfirms 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 3 consecutive years of data for each firm Thecollected data was analyzed using the linear regression function in the Stata software

The thesis conducts research on financial reporting quality, degrees of free cashflow and efficiency between investment decisions; Since then, the thesis concentrates oninvestigating the relationship between financial reporting quality factors, free cash flowand investment performance of listed companies on HOSE

To perform this thesis, panel data is applied to due a number of rationales Sincethe data requires vigorous space and timetime, with data range from 2017 to 2022 ofroughly 200 companies, panel data seems to be the most suitable method Furthermore,the issue regarding heterogeneity among companies and especially the multicollinearityamidst variables could be solved using techniques including in this method

In the analysis of regression models using panel data, there are three prevalentcategories: pooled models, fixed effect models (namely as FEM), and random effectsmodels (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 controllingvariables (Financial solvency, size, age, Tobin’s Q, tangibility, Length of operating cycle,other controlling variables) to make the regression results robust To obtain preciseestimations, a comprehensive examination of all hypotheses tested is necessary Toaccess whether to implement the FEM or REM would result in a more appropriate for themodel, 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 tosufficient data included in the model, the F test and t test are selected to examine whetherthey vary from 0 As reported by Hinkle (2003), to handle the issue regardingmulticollinearity, there had been a significant problem regarding collinearity, leading tothe difficulty to measure the regression coefficients

4 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 freecash 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 alsodescribes 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

5 Literature review

5.1 Definition of asymmetric information and agency problems

Speaking about governance or corporate administration, the sovereign objective ofthe company head is to attain the sustainable growth over time But, the first andforemost worry that bother the investors is the asymmetric information and the agencyproblems, which leading to several loss to investors Therefore, it is crucial for firms tominimize 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 bymanipulating the data to compose the financial reports This can have large impact on theinvestment decisions of owners For instances, on the side of creditors, creditors alwayswant businesses to invest in projects with low risk, bringing stable cash flow so that theycan 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 ofmaximizing the owner's interests First, the business operator, for his own benefit, canchoose non-optimal projects with low returns; low-risk and unconcerned withshareholders' 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 thebusiness 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 helpsexecutives increase current income levels despite the interests of shareholders andcreditors 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 risksinvolved Inefficiency investment decisions could be the result of conflicts among themanagers, the creditors and the shareholders To measure the investment efficiency, theapproach can be seperated into overinvestment and underinvestment

Based on research conducted by Jensen (1986), those firms with superfluous cashindicate the projects that the managers had invested in are not effective, but more aboutpersonal 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 Theinvestors might interested in risky projects with highly return, as receive dividends inshort term In short, these projects provide more advantages to creditors compared toshareholders Therefore, there would be no investment in new projects, which can harmthe 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 orassets, resulting in a decrease in the firm's value It occurs when a company has access toexcess capital and cannot identify sufficient profitable investment opportunities Onearticle that relates to the topic and discusses overinvestment is "Investment inefficiencyand overinvestment: Evidence from Chinese firms" by Kuan Xu and Yan Wang (2018).The authors investigate the relationship between overinvestment and investmentefficiency for Chinese firms and find that overinvestment leads to lower investment

efficiency They also suggest that external financing constraints can exacerbate thenegative effects of overinvestment on investment efficiency.

5.2.2 Underinvestment definition

Underinvestment refers to a situation where a firm invests less than what isrequired for the optimal level of investments based on the available opportunities Thiscan occur due to a variety of reasons such as financial constraints, lack of access tocapital, managerial preferences, or uncertainty about future market conditions An articlepublished by T V., Nguyen, H T T., etc (2020), investigates the impact of free cashflow and financial reporting quality on underinvestment in Vietnamese listed firms Theauthors argue that underinvestment occurs when firms do not invest enough in profitableprojects, leading to reduced future growth opportunities and lower profitability They findthat 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 betterfinancial reporting quality are less likely to underinvest The study highlights theimportance of managing free cash flow and maintaining high levels of financial reportingquality to avoid underinvestment and promote sustainable growth for Vietnamese listedfirms

5.3 Definition of financial reporting quality & free cash flow

Financial reporting quality refers to the degree of accuracy, transparency, andcompleteness in financial reporting High-quality financial reporting provides reliableinformation that can be used to make informed decisions about investment opportunities.The impact of financial reporting quality on investment efficiency is a crucial topic, andmany researchers have studied this area One key factor that impacts investmentefficiency is free cash flow (FCF), which is the cash generated after deducting businessexpenses from income In a perfect market with no asymmetric information or moralhazard, there is no relationship between financial reporting quality and FCF However, inthe imperfect market, the existence of asymmetric information and agency problems canmake it difficult for firms to get funds from external capital markets Therefore, financial

constraints can lead to underinvestment, and the conflict between managers andshareholders can cause overinvestment.

Several studies have explored the relationship between financial reporting qualityand investment efficiency Biddle and Hilary (2006) conducted research in America andJapan from 1993 to 2004 and found that FRQ enhances investment efficiency Similarly,Chen et al (2011) found that FRQ contributes to an improving investment performance

in 79 developing countries from 2002 to 2005 Financial reporting quality can impactinvestment decision based on two criteria: asymmetric information and agency problems.Asymmetric information can be reduced by financial reporting quality through fulldisclosure of private information, which can help reduce the cost of raising capital andprevent the negative impact of adverse selection Agency problems can be reducedthrough financial reporting quality by using compensation agreements and debt contractsbased on financial reporting

Gomariz and Ballesta (2014) studied the effects of FRQ from 1998 to 2008 inSpain and found that FRQ limited overinvestment problems They also recommendedthat short debt maturities could improve investment efficiency by reducingunderinvestment through financial reporting quality Fazzari et al (2000) analyzed asample of 49 low-dividend firms and found that firms with poor liquidity faced theunderinvestment problem, while overinvestment often existed in firms with redundancycash The quality of accounting based on financial information can help solve thisproblem by providing precise internal information about the evaluation of new projects.High-quality financial reporting allows firms to invest in potential projects and eliminateunnecessary ones, leading to improved investment efficiency

In conclusion, financial reporting quality can have a significant impact oninvestment efficiency by reducing asymmetric information and agency problems Whilefree cash flow is a crucial factor in investment efficiency, the conflict between managers

and shareholders can cause overinvestment Therefore, financial reporting quality plays acritical role in improving investment efficiency by providing accurate financialinformation for effective investment decision-making.

5.4 The impact of financial reporting quality & free cash flow on

investment efficiency

Free cash flow (FCF) is a significant factor for expanding businesses, payingdividends and debts, and investing It is defined as the amount of cash generated from theresult of deduction of expenses from income under business activities In perfect marketswith no asymmetric information and moral hazard, there is no relationship betweenfinancial reporting quality and free cash flow However, in imperfect markets where there

is the existence of asymmetric information and agency problems, financial reportingquality plays a crucial role in mitigating the obstacles for firms to get funds from externalcapital markets In such markets, the monitoring of capital providers is challenging, sofirms depend on the effective use of internal cash flow to invest in new projects andmobilize external funding Asymmetric information can also influence firms with largefree cash flow and low development opportunities to spend money on low-profit projects,leading to overinvestment The conflict between shareholders and managers regarding theuse of free cash flow can lead to value destruction in acquisitions due to agency costs.However, if information is clear, investment efficiency can increase through free cashflow because it leads to the increasing role of shareholders, bondholders, and debt holders

in monitoring

Several studies have explored the relationship between free cash flow andinvestment efficiency Jensen (1986) conducted research in the oil sector in Americabetween 1970 and 1980 and found that managers tend to invest in projects with lower-than-average profit rather than returning excess cash flow to shareholders Harford (1999)collected a sample of 487 takeover bids in the US between 1950 and 1994 and found thatfirms with large free cash flow tend to make ineffective acquisitions due to agency costs.Lamont (1997) tested the relation between cash flow and investment in the non-oil

segments of oil companies in 1986 and found that the investment falls due to thereduction of internal finance such as cash flow and collateral value, which causes limitedexpenditure in the case of overinvestment Overall, firms with high free cash flow facethe risk of overinvestment due to agency problems, but financial reporting quality canmitigate such problems The interaction between financial reporting quality and free cashflow promotes investment efficiency by lowering the cost of monitoring managers andimproving project selection through high FRQ Furthermore, managers of firms withlarge cash balances and free cash flows tend to overspend actual resources, which can bemitigated by high FRQ.

6 Formulating hypotheses

As reported by Xinyu Cheng, Wei Jiang, and Yushu Zhu (2021), by using asample of 1,326 SOEs from 2009 to 2018, the authors found that higher financialreporting quality is associated with higher investment efficiency, indicating a negativerelationship between financial reporting quality and underinvestment The authors alsofound that financial reporting quality is more important for SOEs with lower stateownership and higher debt levels, suggesting that financial reporting quality can helpmitigate agency problems and information asymmetry in these firms

Figure 1: Relationship between investment efficiency and financial reporting quality

Considering the aforementioned points and Figure 1 which summarizes theliterature review, the author has formulated four hypotheses for the study:

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.

CHAPTER III DATA COLLECTION AND RESEARCH METHODOLOGY

This chapter points out the dataset collection & processing, types of data and describes in details the regression models & variables in the models.

7 Introduction to dataset

7.1 Data collection

This study utilizes a quantitative methodology and gathers data from FiinPro, ahighly reputable financial data provider, on 200 Vietnamese corporations listed on theHochiminh Stock Exchange (HOSE) The choice of using the HOSE was due to itstransparency as one of the official stock exchanges in Vietnam To examine the researchquestions, a longitudinal approach using panel data was adopted, analyzing threeconsecutive years of data for each firm from 2019 to 2021 The collected data wasanalyzed through the linear regression function available in Stata software

Time series data refers to data collected over time for a single individual or entity.For example, if we were collecting data on the stock prices of a certain company, wewould measure the stock prices over time, such as every day for a year.

Panel data, also known as longitudinal data, combines cross sectional and timeseries data Panel data refers to data collected over time for multiple individuals orentities For example, if we were collecting data on the income of people in a certain cityover a period of five years, we would measure the income of the same individuals eachyear for five years

Panel data allows for the analysis of changes over time within each individual orentity, as well as differences between individuals or entities This type of data is oftenused in economic and social research to examine changes and trends in a particularpopulation However, in this study, panel data is implemented Panel data combines bothcross-sectional and time-series data by observing a group of individuals or entities over aperiod of time By collecting data from the same individuals or entities over time, paneldata provides more detailed and accurate information about the effects of changes overtime and individual differences This data is particularly useful when studying therelationship between variables, such as the impact of financial reporting quality and freecash flow on investment efficiency One of the main advantages of panel data is its ability

to control for unobserved heterogeneity across individuals or entities This means thatpanel data can account for the differences that exist between individual entities, such asdifferences in management style, culture, or other factors that can impact the relationshipbetween variables This control for unobserved heterogeneity allows for more accurateand precise estimates of the relationship between variables

In conclusion, panel data is a powerful tool in research that allows for moredetailed and accurate information on changes over time and individual differences Itsability to control for unobserved heterogeneity, provide statistical power, and be cost-effective make it a preferred choice for many researchers, particularly in studying therelationship between variables over time

8 Regression methodology

8.1 Pooled OLS model

Pooled OLS (Ordinary Least Squares) is a statistical method used in panel dataanalysis to estimate the relationship between the dependent variable and the independentvariables across time and individuals It is a commonly used technique in econometricsfor estimating panel data regression models

The model for pooled OLS can be written as:

Yit = α1 + β1X1it + + βkXkit + Uit

In which:

Yit is the dependent variable for individual i at time t, Xkit is the value ofindependent variable k for individual i at time t, βk is the coefficient for independentvariable k, α1 is the intercept term, and Uit is the error term for individual i at time t

Pooled OLS can be useful when the data set is large and the individual-specific ortime-specific effects on the dependent variable are expected to be small or negligible.However, pooled OLS may not be appropriate when there are significant individual-specific or time-specific effects that are not accounted for in the model, leading to biasedestimates of the coefficients In such cases, fixed effects or random effects models may

be more appropriate

8.2 Fixed effect model

Fixed effects model (FEM) is a panel data regression model that accounts forunobserved heterogeneity, or differences in individuals or entities that are not captured bythe observed variables in the model The basic idea of the fixed effects model is tocontrol for these unobserved differences by including individual-specific or entity-specific fixed effects in the regression

The model for fixed effect model can be written as:

Yit = α1 + β1X1it + + βkXkit + Uit with Uit = vit +εit.

In which:

where Yit is the dependent variable for individual i at time t, Xkit is the value ofindependent variable k for individual i at time t, βk is the coefficient for independentvariable k, α1 is the fixed effect for individual i, and Uit is the error term for individual i