The value relevance of R&D and free cash flow in an efficient investment setup

Abstract

Purpose-The purpose of this paper is to investigate the value relevance of Research and development (R&D) and free cash flow (FCF) in an efficient investment setup. Most importantly, this paper examines whether the value relevance of R&D and FCF is associated with life cycle stages. Furthermore, this paper reports whether the market response to R&D and FCF is different in competitive market as compared to the concentrated market. Design/methodology/approach-The analysis is based on the Ohlson (1995) model for the determination of value relevance of earnings and book value. Capitalized R&D and FCF data comprising of the Chinese A-listed firms from the year 2008 to 2016 are selected for this study. Following Anthony and Ramesh (1992), the authors divided the firm life cycle into different stages. HHI index is used to measure the product market competition. Findings-The main result shows that R&D and FCF are value relevant in Chinese A-listed firms. The impact of R&D and FCF on the value relevance of earnings and book value is also positive and significant. The findings of the effect of R&D and FCF on the value relevance of accounting information signify that the information content (R 2 ¼ 0.46) of the mature stage is higher than that of the growth and stagnant stage. The explanatory power measured by R 2 value for competitive industries (0.47) is much higher than the concentrated industries (0.33). Research limitations/implications-Despite taking into account all the possible available variables, there are few limitations of the study. This study only studies the effect of EPS, BPS, R&D and FCF on the value relevance of accounting information. Other determinant such as size, growth, leverage and firm age is ignored. Since the R&D expenditure is discretionary, therefore the findings cannot be generalized to all the sectors. A sector wise comparative study can be done in future, to understand the differences in the information contents of R&D and FCF. Also, the tax effect of R&D is ignored in this study. For future call, the value relevance of tax effect on R&D can be explored. Practical implications-The investors can now determine the present value of all the future cash flows of investing activities. The results of the study are significant for the Chinese investors who should incorporate the R&D and FCF along with investment efficiency. The investors should keep in mind the life cycle stage while investing in a certain stock. The competitive markets have more information content than the concentrated markets. The corporate managers can benefit from this study while issuing new shares. The market responds The value relevance of R&D and free cash flow positively to the stock having investment efficient R&D and FCF investment. For the policy implication perspective, the security market regulator should devise the effective pro-effective product market regulations. Originality/value-The contribution of this study is manifold. First, according to the authors' knowledge, this is the first study that incorporates investment efficiency with R&D and FCF and explores its effect on the value relevance of accounting information. Second, the impact of R&D on the value relevance is studied by numerous researchers (Lev and Sougiannis, 1996; Han and Manry, 2004). Similarly, FCF-agency cost effect has also been investigated by (Rahman and Mohd-Saleh, 2008; Chen et al., 2012) but the value relevance of R&D and FCF during different life cycle stages still needs to be answered. Finally, this study also tries to answers the question if the market response to R&D and FCF is different in a competitive market as compared to the concentrated market. 1. Introduction The wealth maximization of the principals is the primary goal of a financial manager. For this purpose, the manager should allocate funds at his disposal very efficiently and effectively. Agency theory suggests that opportunistic managers may indulge self-empire buildings if they have too much funds at disposal (Jensen and Meckling, 1976). Research and development (R&D) investment and free cash flows (FCF) are two sources that are regarded as a gauge to measure the information asymmetry. Since managerial discretion determines the level of R&D expenditures and FCF, therefore, the asymmetric problems among managers and principals can be resolved through efficient investment. The financial statements should be value relevant for the efficient investment firms involved in R&D and FCF. Market response to firm R&D and FCF depends upon the life cycle sub-stages. Faff et al. (2016) studied the interdependence of corporate policies during the life cycle stages. They find that during life cycle stages, the investment and equity issuance decreases. We can deduce that the firms need more investment at the early stages; therefore, higher R&D and FCF in early stages are expected. As the firm enters the maturity stage, the firms steady its capital investment and the excess cash is being distributed to the shareholders in the form of dividends. The decline stage is the outcome of the failure of innovation, investing less and distributing more. Due to different priorities of financial manager to varying stages of the lifecycle, the information content of R&D and FCF may differ at each stage. The difference in the information content of R&D and FCF would not only be found among product lifecycle stage, but this difference may also arise due to product market competition. It has been well documented that the product market competition substitutes for corporate governance in frail markets (Giroud and Mueller, 2011; Ammann et al., 2013; Yu et al., 2017). The market response to investment activities is positive in competitive markets. Therefore, we expect a difference in the information content of R&D and FCF in competitive and concentrated industries. The purpose of this study is to explore the value relevance of R&D and FCF for the efficient investment firms. Also, we want to find out how the market response to R&D and FCF among different life cycle stages and during the product market competition. This study focuses on the capitalized amount shown in the balance sheet which signifies the managerial discretion. The old Chinese accounting standards for business enterprises do not require the firms to disclose the R&D expenditures. But after 2007 the Chinese accounting system was transformed to International Accounting Standard Board settings; therefore, firms start to show capitalized R&D expenditures in the balance sheet and hence give useful information to the investors. The contribution of this study is manifold. First, to our knowledge, this is the first study that incorporates investment efficiency with R&D and FCF and explores its effect on the value relevance of accounting information. Second, the impact of R&D on the value relevance is studied by numerous researchers (Lev and Sougiannis, 1996; Han and Manry, 2004). Similarly FCF-agency cost effect has also been investigated by (Rahman and Mohd-Saleh, 2008; Chen et al., 2012) but the value relevance of