Types of Financial Decisions
The decisions regarding the financial matters of any organization are known as Financial Decisions . In simple terms, it refers to the decision regarding the investment of the funds of the business in various assets. Financial management focuses on providing solutions to three significant problems concerned with the firm’s financial operations corresponding to the three questions of investment, financing, and dividend decision. In financial terms, financial decisions refer to finding the best solutions to financial or investment problems from various alternatives.
Types of Financial Decisions
The management of an organization takes several financial decisions to maximize its profits. The finance function deals with three main kinds of decisions are:
Table of Content
- Investment Decision
- Financing Decision
- Dividend Decision
1. Investment Decision
As resources are scarce, a firm has a lot more use of resources than them being present. Thus, a firm has to decide where to invest these resources to earn the highest possible returns for its investors. Therefore, the investment decisions reveal how the firm’s funds are invested in different assets. Investment decisions are of two types- short-term and long-term. A long-term investment decision is also known as a Capital Budgeting decision. Short-term investment decisions deal with the decisions about the levels of cash, inventory, and receivables. They are also known as Working capital decisions.
2. Financing Decision
Financing decisions are concerned with the determination of financial sources, the amount to be obtained from each source, and the value of each source of finance from various long-term sources. The short-term sources come under working capital management. Financing decisions are concerned with the identification of various accessible sources. A firm obtains its main sources of funds from its shareholders or by borrowing funds. The shareholders’ funds refer to the equity capital and the retained earnings. The finance raised through debentures or any other form of debt is known as a borrowed fund. Based on the basic characteristics of each source of funds, the firm determines the proportions of funds raised through them. Whether the firm earns a profit or not, it is bound to pay the interest on the borrowed funds. Similarly, the repayment of the borrowed funds has to be done at a predetermined time. The risk of default on payment is known as a financial risk that has to be taken care of by a firm that probably has insufficient shareholders to make these fixed payments. On the other hand, the funds of the shareholders have no pressure concerning the payment of returns or the repayment of capital.
3. Dividend Decision
The decision that every financial manager has to undertake is concerned with the distribution of dividends. This is known as a dividend decision. The part of the profit which is distributed among the shareholders is known as a dividend. A dividend decision is concerned with how much of the profit earned by the company (after paying tax) is to be given to the shareholders and how much of it is to be reserved by the business. While the dividend comprises the current income, reinvestment, as retained earnings expand the scope of the firm’s future earnings. The financing decision of the firm is also affected by the extent of retained earnings. Since the fund is not needed by the firm to the degree of re-invested retained earnings, the final goal of widening the shareholder’s funds should be taken into consideration while deciding dividends.
Financing Decision: Meaning and Factors affecting Financing Decision
Financial Management is concerned with the management of the flow of funds and involves decisions related to the acquisition and application of funds in long-term and short-term assets. It is concerned with two aspects, they are procurement of funds as well as usage of finance.
Financial decision refers to the decision related to financial matters of a business firm. There are various financial decisions that a firm makes to maximize shareholders’ wealth. There are three major decisions that every financial management takes investment decision , financing decision , and dividend decision .
What is Financing Decision?
The financing decision is about the amount of finance to be raised from various long-term sources, this determines the various sources of finance, as well as it also provides the cost of each source of finance. The main sources of finance are:
- Shareholders’ Funds
- Borrowed Funds
The shareholders’ funds or owners’ funds consist of equity capital and retained earnings, whereas borrowed funds refer to finance raised as debentures or other forms of debt. The borrowed funds contain risk because they involve a commitment of fixed interest payment, although there will be loss in the organisation. On the other hand, owners’ funds have less risk because there is no such commitment regarding payment of dividends and replacement of the capital amount. Financing decisions involve analysing the risk and cost associated with each source of finance. Both sources have their own merits and demerits.
Burrowed funds are considered to be the cheapest source of finance because interest paid is a deductible expense for the calculation of tax liability. The cost of raising finance is known as floatation cost, and it is also considered while taking financing decisions. In this way, the financing decision is related to deciding how much amount is to be raised from each source. This decision determines the overall cost of capital and the financial risk of the enterprise.
Factors Affecting Financing Decision
There are various factors that affect the financing decision. These are as follows:
1. Cost:
The cost of raising funds from different sources is different. A financing manager generally prefers the cheapest source of finance.
2. Risk:
The risk associated with different sources of finance is a different borrowed fund has a high degree of risk, as compared to the owners. The financial manager considers the risk involved with each source before taking a financing decision. In the case of equity, the risk is low, and in the case of debt, the risk is high.
3. Floatation Cost:
Floatation cost refers to the cost, which is involved in the issue of securities. In the case of equity, floatation cost is low, and in the case of debt, floatation cost is high. Some of the examples are underwriting commission, broken range stamp duty, etc. The firm prefers securities with the least floatation cost.
4. Cash Flow Position:
A company with a strong cash flow position can take the advantage of debt because interest payment and re-payment of principal amount can be preferred by companies when there will be a shortage of cash.
5. Level of Fixed Operating Costs:
Owner’s fund is preferred by firms with a higher level of operating costs, like rent, salaries, insurance premiums, etc., because interests payment on debt will further add to the cost burden. And in case of moderate or low fixed operating costs, firms can go for borrowed funds.
6. Control Consideration:
The issue of more equity shares may lead to a dilution of management control over the business. Debt financing has no such implication. Companies that are afraid of taking over will prefer debt. It means if existing shareholders want to retain complete control of the company, then the debt should be preferred. However, if they don’t mind the loss of control, then the company may go for equity. So we can say that equity dilutes control, whereas debt doesn’t affect control.
7. State of Capital Market:
The condition of the stock market also helps in making the source of finance. In the case when the stock market is rising, during this period it is also easy to raise funds for the issue of shares because people are interested to invest in equity shares. But in case of a depressed market, company may face difficulties for issue equity shares.
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