Financing Decisions

What is the Financing Decision?

The Financing Decision is a crucial decision that is to be made by the financial manager, the decision is about the financing-mix of an organization. Financing Decision is focused on the borrowing and allocation of funds required for the investment decisions of the firm. We will learn in detail about these various financing decisions in the upcoming section.

 

The financing decision comes from two sources from where the funds can be raised – first is from the company’s own money, such as the share capital, retained earnings. Second is from borrowing funds from the outside the corporate in the form debenture, loan, bond, etc. The objective of the financial decision is to balance an optimum capital structure.

What are the Basic Financial Decisions?

Basic Financial Decisions that financial managers need to take:

  • Investment Decision

  • Financing Decision and

  • Dividend Decision

Investment Decision

Also known as the Capital Budgeting Decisions. A company’s assets and resources are very rare and thus must be put to use with much analysis. A firm should pick those investments where he can gain the highest conceivable returns. Investment decision involves careful selection of the assets where funds will be invested by the corporates. 

Financing Decision

Financial decision is the utmost important decision which is to be made by business individuals. These are wise decisions indeed that are to be chalked out with proper analysis. He decides when, where and how should the business acquire the fund. An organization’s increase in share is not only a sign of development for the firm but also to boost the investor’s wealth. 

Dividend Decision

Dividend decisions relate to the distribution of profit that are earned by the organization. The main criteria in this decision are whether to distribute to the shareholders or to retain the earnings. Dividend decisions are affected by the earnings of the business, dependency on earnings.

Importance of Financial Decision Making

  1. Long-term Growth and Effect:

Financial decisions are concerned with the long-term use of assets. These assets are very helpful in the process of production. Profit is also earned by selling the goods that are produced. This can, therefore, be accurate decisions. The greater the growth of business in the long run, the more effective the decision needs to be. In addition to that, these affect the future prospect of the business.

  1. Large Amount of Funds Involved:

Funds are the base of this business decision. Decisions regarding the fixed assets are included in the context of capital budgeting. Huge capital is invested in these assets. If these decisions turn out to be a flaw, then it will cause heavy loss of capital which is indeed a scarce resource.

  1. Risk Involved:

Capital budgeting decisions come with risks. There are two reasons for the risk factor to be involved in it. First, these decisions are analysed for a long period, and thus the expected profits for several years are to be anticipated which even lead to fluctuations. These are human estimations which may turn out to be wrong. Secondly, as a heavy investment is involved, it is very difficult to change the decision once it has been taken.

  1. Irreversible Decisions:

Nature of these decisions is irreversible, once taken it cannot be reformed. For instance, if soon after setting up a sugar mill, the owner thought of changing it, then the old machinery used for the purpose and other fixed assets will have to be sold at a loss. In doing this, the heavy loss will have to be incurred by the owner.

 

A business constitutes two major things: money and the decision through which the business runs efficiently. Without money, the survival of the company could be impossible and without decisions, survival of money could be impossible. The lifetime of the company completely depends on the countless decisions an administration makes. Probably, the most important things are regarding money. The money decisions related are called ‘Financing Decisions.’


Financial managers take three kinds of decisions they are,

  • Investment Decision

  • Financing Decision and

  • Dividend Decision

Investment Decision

Investment Decision is also referred to as Capital Budgeting Decisions. The assets and resources of the company are rare and must be put into utmost utilization. In order to gain the highest conceivable returns, a firm should pick where to invest.  Funds will be invested based on the careful selection of assets by the firms. In procuring fixed assets and current assets, the firm funds are invested. If the choice is taken with respect to a fixed asset it is called a capital budgeting decision.

Factors Affecting Investment Decision

  • Cash flow of the venture: If an organization starts a venture it begins to invest a large amount of capital at the initial stage. Though, the organization expects at least a source of income to meet daily expenses. Hence, within the venture, there must be some regular cash flow to sustain.

  • Profits: The fundamental criteria to start a venture is to generate income but moreover profits. The most crucial criteria in choosing the venture involve the rate of return for the organization with respect to its profit nature. For example: if venture A  gets 10% return and venture В gets 15% return then project B must be preferred.

  • Investment Criteria: Various Capital Budgeting procedures are used for a business to assess various investment propositions. Most importantly, they are based on calculations with respect to investment, interest rates, cash flows, and rate of returns associated with propositions. These are applied to the investment proposals to make a decision on the best proposal.

Financing Decision

Financial decision is significant in decision-making on when, where, and how a business acquire funds. When the market estimation of an organization’s share expands the firm tends to gain more profit, it is not only a sign of development of the firm but also fastens investors’ wealth. 

Factors Affecting Financing Decisions

  • Cost: Financing decisions are based on the allocation of funds and cost-cutting. The cost of fundraising from different sources differs a lot and the most cost-efficient source should be chosen.

  • Risk: The dangers of starting a venture with funds differ based on various sources. Borrowed funds have a larger risk compared to equity funds. 

  • Cash flow position: Cash flow is the daily earnings of the company. A good cash flow position gives confidence to the investors to invest funds in the company.

  • Control: In this case where existing investors hold control of the business and raise finance through borrowing money, however, equity can be utilized for raising funds when they are prepared for diluting control of the business.

  • Condition of the market: The condition of the market plays a major role in financing decisions. Issuance of equity is in majority during the boom period, but debt of a firm is used during a depression. 

FAQs on Financing Decisions

1. What are Retained Earnings?

Retained earnings abbreviated as RE is the amount of net income that is the leftover for the business after it has paid out all the dividends to its shareholders. A business generates these earnings from the residue left after all payment from the profit incurred, which can be positive (profits) or even negative (losses).

2. What is the Optimal Capital Structure?

An adequate, balanced and proper mix of debt and equity, to ensure the trade-off between the risk and return to the shareholders is termed as the Optimal Capital Structure. A business always attempts to stay in this zone, as here the risk is minimum.  A simple way to minimize the difference is by lessening the weighted average cost of capital (WACC).

3. What are the Factors that Affect the Investment Decisions?

The factors that affect the Investment Decisions are as follows – 

  • The cash flow of the venture

  • Profits

  • Investment Criteria

4. What are the Criteria for Dividend Decision?

The main factors which influence the dividend decisions are as follows:

  • Growth and Profitability of the business.

  • Liquidity capability of the business.

  • Cost and Availability of the other forms of financing.

  • Management Control.

  • Legal factors.

  • Reach to the Capital Market.

  • Other External Restrictions.

Comment