Financial Decisions

The financial decision is concerned with determining how much money will be raised from which long-term source, such as shareholder cash or borrowed funds. Borrowed funds comprise debentures, long-term loans, and public deposits, whereas shareholders’ funds include share capital, reserves, surplus, and retained earnings.

There are two approaches to discussing factors that influence financial decisions. Internal and external factors are the two types. Internal factors include the nature of the firm, its size, its structure, and the structure of its assets, among others. Economic conditions, tax policy, government regulation, capital structure, and financial markets are all examples of external factors.

Three Important Financial Decisions

Every business must make three major financial decisions, which are as follows:

1. Choosing an Investment

The investment decision is a financial decision that deals with how a company’s cash is invested in various assets. A long-term or short-term investment decision can be made.

A capital budgeting decision is a long-term investment decision that involves large quantities of long-term investments and is irreversible except at a high cost. Working capital decisions are short-term investment decisions that affect a company’s day-to-day operations. It covers decisions concerning cash, inventory, and receivables levels.

2. Decision on Financing

A financial decision includes the amount of money to be raised from various long-term funding sources such as equity shares, preference shares, debentures, bank loans, and so on. This is referred to as a funding decision. In other words, it is a decision on the company’s ‘capital structure.’

3. Dividend Decision:

The dividend decision is a financial decision that involves determining how much of a company’s profit should be delivered to shareholders (dividend) and how much should be preserved for future contingencies (retained earnings).

The part of the profit that is distributed to shareholders is referred to as a dividend. The choice of dividends should be made with the broader goal of increasing shareholder wealth in mind.

Factors Impacting Financial Decision

The following are some of the most critical factors that impact the financial decisions of the company:

(a) Cost:

The allocation of finances and cost-cutting are at the heart of all financing decisions. The costs of obtaining finances from various sources fluctuate. A prudent financial manager would generally choose the cheapest source. The most cost-effective option should be chosen.

(b) Risk: 

The risk associated with various sources varies. The finance manager weighs the risk against the cost and favours securities with a low-risk factor. The risk associated with borrowed funds is higher than that associated with equity funds. One of the most important parts of funding decisions is risk assessment.

(c) Floatation Costs: 

The source becomes less appealing as the flotation cost rises. It refers to charges associated with the issuance of securities, such as broker commissions, underwriters’ fees, prospectus expenses, and so on. The higher a source’s flotation cost, the less appealing it appears to management.

(d) Cash Flow Position of the Business:

Debt financing may be more attractive than equity financing due to a higher cash flow situation. Companies with consistent cash flow can readily afford borrowed fund securities, but when cash flow is scarce, they must rely solely on owner’s fund securities. A positive or negative cash flow position encourages or discourages investors to invest in the company.

(e) Level of Fixed Operating Costs: 

If a company’s fixed operating costs are high, it’s a good sign (e.g., building rent, Insurance premium, Salaries, etc.). It must choose fixed financing expenses that are lower. As a result, debt financing with a lower interest rate is preferable. In the same way, if the fixed operational costs are lower, greater debt financing may be selected.

(f) Control Considerations: 

More equity issues may result in a dilution of management’s influence over the company. Debt finance, on the other hand, has no such implications. As a result, companies that are fearful of a takeover proposal may prefer debt to stock. Existing shareholders prefer borrowed fund securities to raise more funds if they want to keep the entire control of the company.

(g) Tax Rate: 

The cost of debt is influenced by the tax rate because interest is a deductible item. Because interest is a tax-deductible expense, a higher tax rate lowers the cost of debt and makes it more appealing than equity. Debt financing becomes more appealing when the tax rate is greater.

(h) Condition of the market:

The state of the market has a significant impact on financing decisions. During a boom, equity is the most common issue, but during a downturn, a company will have to rely on debt. These decisions are crucial in the funding process.

Conclusion

This financial decision pertains to how, when, and where funds will be obtained to meet investment requirements. It has something to do with financial leverage or capital structure. This is referred to as the debt-to-equity ratio. Shareholders’ risk is lowered and their chances of receiving dividends are reduced if more loan money is used. As a result, the trade-off between returned risks is critical in financing decisions.