Financial Decision

24/03/2020 3 By indiafreenotes

The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of funds required for the investment decisions.

The financing decision involves two sources from where the funds can be raised: using a company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to the shareholders.

The Debt-Equity Ratio helps in determining the effectiveness of the financing decision made by the company. While taking the financial decisions, the finance manager has to take the following points into consideration:

  • The Risk involved in raising the funds. The risk is higher in the case of debt as compared to the equity.
  • The Cost involved in raising the funds. The manager chose the source with minimum cost.
  • The Level of Control, the shareholders, want in the organization also determines the composition of capital structure. They usually prefer the borrowed funds since it does not dilute the ownership.
  • The Cash Flow from the operations of the business also determines the source from where the funds shall be raised. High cash flow enables to borrow debt as interest can be easily paid.
  • The Floatation Cost such as broker’s commission, underwriters fee, involved in raising the securities also determines the source of fund. Thus, securities with minimum cost must be chosen.

Thus, a company should make a judicious decision regarding from where, when, how the funds shall be raised, since, more use of equity will result in the dilution of ownership and whereas, higher debt results in higher risk, as fixed cost in the form of interest is to be paid on the borrowed funds.

Types of Financial Decisions

  1. Investment Decision

A financial decision which is concerned with how the firm’s funds are invested in different assets is known as investment decision. Investment decision can be long-term or short-term.

A long term investment decision is called capital budgeting decisions which involve huge amounts of long term investments and are irreversible except at a huge cost. Short-term investment decisions are called working capital decisions, which affect day to day working of a business. It includes the decisions about the levels of cash, inventory and receivables.

A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.

A bad working capital decision affects the liquidity and profitability of a business.

Factors Affecting Investment Decisions / Capital Budgeting Decisions

(i) Cash flows of the project: The series of cash receipts and payments over the life of an investment proposal should be considered and analyzed for selecting the best proposal.

(ii) Rate of return: The expected returns from each proposal and risk involved in them should be taken into account to select the best proposal.

(iii) Investment criteria involved: The various investment proposals are evaluated on the basis of capital budgeting techniques. Which involve calculation regarding investment amount, interest rate, cash flows, rate of return etc. It is to be considered which technique to use for evaluation of projects.

  1. Financing Decision

A financial decision which is concerned with the amount of finance to be raised from various long term sources of funds like, equity shares, preference shares, debentures, bank loans etc. Is called financing decision. In other words, it is a decision on the ‘capital structure’ of the company.

Capital Structure Owner’s Fund + Borrowed Fund

Financial Risk: The risk of default on payment of periodical interest and repayment of capital on ‘borrowed funds’ is called financial risk.

Factors Affecting Financing Decision

(i) Cost: The cost of raising funds from different sources is different. The cost of equity is more than the cost of debts. The cheapest source should be selected prudently.

(ii) Risk: The risk associated with different sources is different. More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid after a fixed period of time or on expiry of its tenure.

(iii) Flotation cost: The cost involved in issuing securities such as broker’s commission, underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the flotation cost, less attractive is the source of finance.

(iv) Cash flow position of the business: In case the cash flow position of a company is good enough then it can easily use borrowed funds.

(v) Control considerations: In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds but when they are ready for dilution of control over business, equity shares can be used for raising finance.

(vi) State of capital markets: During boom period, finance can easily be raised by issuing shares but during depression period, raising finance by means of debt is easy.

  1. Dividend Decision

A financial decision which is concerned with deciding how much of the profit earned by the company should be distributed among shareholders (dividend) and how much should be retained for the future contingencies (retained earnings) is called dividend decision.

Dividend refers to that part of the profit which is distributed to shareholders. The decision regarding dividend should be taken keeping in view the overall objective of maximizing shareholder s wealth.

Factors affecting Dividend Decision

(i) Earnings: Company having high and stable earning could declare high rate of dividends as dividends are paid out of current and past earnings.

(ii) Stability of dividends: Companies generally follow the policy of stable dividend. The dividend per share is not altered in case earning changes by small proportion or increase in earnings is temporary in nature.

(iii) Growth prospects: In case there are growth prospects for the company in the near future then, it will retain its earnings and thus, no or less dividend will be declared.

(iv) Cash flow positions: Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.

(v) Preference of shareholders: While deciding about dividend the preference of shareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same. In such case the amount of dividend depends upon the degree of expectations of shareholders.

(vi) Taxation policy: A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower, then more dividends can be declared by the company.