Learn and Understand, Factors Affecting the Major Types of Financial Decisions!
Definition: The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerning the borrowing and allocation of funds required for the investment decisions. Types of Decisions: i. Investment decision ii. Financing decision iii. Dividend decision iv. Liquidity Decision. Also learn, Simple Types of Financial Decisions, Factors Affecting the Major Types of Financial Decisions!
Some of the important functions which every finance manager has to take are as follows:
A. Investment decision.
B. Financing decision.
C. Dividend decision, and.
D. Liquidity Decision.
The following decision is explained below:
A. Investment Decision (Also Know, Capital Budgeting Decision):
This decision relates to the careful selection of assets in which funds will be invested by the firms. A firm has many options to invest their funds but the firm has to select the most appropriate investment which will bring maximum benefit to the firm and decide or selecting most appropriate proposal is investment decision.
The firm invests its funds in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is also called capital budgeting decision.
Factors Affecting Investment/Capital Budgeting Decisions:
1. Cash Flow of the Project:
Whenever a company is investing huge funds in an investment proposal it expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an investment proposal will be able to generate must assess properly before investing in the proposal.
2. Return on Investment:
The most important criteria to decide the investment proposal is the rate of return it will be able to bring back for the company in the form of income for, e.g., if project A is bringing 10% return and project В is bringing 15% return then we should prefer project B.
3. Risk Involved:
With every investment proposal, there is some degree of risk is also involved. The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with the moderate degree of risk only.
4. Investment Criteria:
Along with return, risk, cash flow there are various other criteria which help in selecting an investment proposal such as availability of labor, technologies, input, machinery, etc.
The finance manager must compare all the available alternatives very carefully and then only decide where to invest the most scarce resources of the firm, i.e., finance.
Investment decisions are considered very important decisions because of following reasons:
(i) They are long-term decisions and therefore are irreversible; means once taken cannot change.
(ii) Involve huge amount of funds.
(iii) Affect the future earning capacity of the company.
Importance or Scope of Capital Budgeting Decision:
Capital budgeting decisions can turn the fortune of a company. The capital budgeting decisions are considered very important because of the following reasons:
1. Long-Term Growth:
The capital budgeting decisions affect the long-term growth of the company. As funds invested in long-term assets bring the return in future and future prospects and growth of the company depend upon these decisions only.
2. Large Amount of Funds Involved:
Investment in long-term projects or buying of fixed assets involves the huge amount of funds and if the wrong proposal is selected it may result in wastage of huge amount of funds that is why capital budgeting decisions are taken after considering various factors and planning.
3. Risk Involved:
The fixed capital decisions involve huge funds and also the big risk because the return comes in long run and company has to bear the risk for a long period of time till the returns start coming.
4. Irreversible Decision:
Capital budgeting decisions cannot reverse or change overnight. As these decisions involve huge funds and heavy cost and going back or reversing the decision may result in heavy loss and wastage of funds. So these decisions must take after careful planning and evaluation of all the effects of that decision because adverse consequences may be very heavy.
B. Financing Decision:
The second important decision which finance manager has to take is deciding source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loan and advances. Deciding how much to raise from which source is the concern of financing decision.
Mainly sources of finance can divide into two categories:
- Owners fund.
Share capital and retained earnings constitute owners’ fund and debentures, loans, bonds, etc. constitute borrowed fund.
The main concern of finance manager is to decide how much to raise from owners’ fund and how much to raise from a borrowed fund.
While taking this decision the finance manager compares the advantages and disadvantages of different sources of finance. The borrowed funds have to pay back and involve some degree of risk whereas in owners’ fund there is no fixing commitment of repayment and there is no risk involved. But finance manager prefers a mix of both types. Under financing, decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.
Factors Affecting Financing Decisions:
While taking financing decisions the finance manager keeps in mind the following factors:
The cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost.
More risk is associated with the borrowed fund as compared to owner’s fund securities. Finance manager compares the risk with the cost involved and prefers securities with the moderate risk factor.
3. Cash Flow Position:
The cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have a shortage of cash flow, then they must go for owner’s fund securities only.
4. Control Considerations:
If existing shareholders want to retain the complete control of business then they prefer borrowed fund securities to raise further fund. On the other hand, if they do not mind to lose the control then they may go for owner’s fund securities.
5. Floatation Cost:
It refers to the cost involved in the issue of securities such as broker’s commission, underwriters fees, expenses on the prospectus, etc. The firm prefers securities which involve least floatation cost.
6. Fixed Operating Cost:
If a company is having high fixed operating cost then they must prefer owner’s fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for the company.
7. State of Capital Market:
The conditions in capital market also help in deciding the type of securities to raise. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in the capital market.
C. Dividend Decision:
This decision is concerned with the distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, debenture holders, shareholders, etc.
Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what company or finance manager has to decide is what to do with the residual or left over the profit of the company.
The surplus profit is either distributed to equity shareholders in the form of the dividend or kept aside in the form of retained earnings. Under dividend decision, the finance manager decides how much to distribute in the form of dividend and how much to keep aside as retained earnings.
To take this decision finance manager keeps in mind the growth plans and investment opportunities.
If more investment opportunities are available and company has growth plans then more is kept aside as retained earnings and less is given in the form of dividend, but if company wants to satisfy its shareholders and has fewer growth plans, then more is given in the form of dividend and less is kept aside as retained earnings.
This decision is also called residual decision because it is concerned with the distribution of residual or leftover income. Generally new and upcoming companies keep aside more of retain earning and distribute less dividend whereas established companies prefer to give more dividend and keep aside less profit.
Factors Affecting Dividend Decision:
The finance manager analyses following factors before dividing the net earnings between dividend and retained earnings:
Dividends are paid out of current and previous year’s earnings. If there are more earnings then company declares the high rate of dividend whereas during the low earning period the rate of dividend is also low.
2. Stability of Earnings:
Companies having stable or smooth earnings prefer to give the high rate of dividend whereas companies with unstable earnings prefer to give the low rate of earnings.
3. Cash Flow Position:
Paying dividend means outflow of cash. Companies declare the high rate of dividend only when they have surplus cash. In the situation of shortage of cash, companies declare no or very low dividend.
4. Growth Opportunities:
If a company has a number of investment plans then it should reinvest the earnings of the company. As to invest in investment projects, the company has two options: one to raise additional capital or invest its retained earnings. The retained earnings are the cheaper source as they do not involve floatation cost and any legal formalities.
If companies have no investment or growth plans then it would be better to distribute more in the form of the dividend. Generally, mature companies declare more dividends whereas growing companies keep aside more retained earnings.
5. Stability of Dividend:
Some companies follow a stable dividend policy as it has the better impact on shareholder and improves the reputation of the company in the share market. The stable dividend policy satisfies the investor. Even big companies and financial institutions prefer to invest in a company with regular and stable dividend policy.
There are three types of stable dividend policies which a company may follow:
(i) Constant dividend per share:
In this case, the company decides a fixed rate of dividend and declares the same rate every year, e.g., 10% dividend on investment.
(ii) Constant payout ratio:
Under this system, the company fixes up a fixed percentage of dividends on profit and not on investment, e.g., 10% on profit so dividend keeps on changing with the change in profit rate.
(iii) Constant dividend per share and extra dividend:
Under this scheme, a fixed rate of dividend on investment is given and if profit or earnings increase then some extra dividend in the form of bonus or interim dividend is also given.
Another important factor affecting dividend policy is expectation and preference of shareholders as their expectations cannot ignore the company. Generally, it is observed that retired shareholders expect the regular and stable amount of dividend whereas young shareholders prefer capital gain by reinvesting the income of the company.
They are ready to sacrifice present-day income dividend for future gain which they will get with growth and expansion of the company.
Secondly poor and middle-class investors also prefer the regular and stable amount of dividend whereas wealthy and rich class prefers capital gains.
So if a company is having a large number of retired and middle-class shareholders then it will declare more dividend and keep aside less in the form of retained earnings whereas if company is having a large number of young and wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and declare low rate of dividend.
7. Taxation Policy:
The rate of dividend also depends upon the taxation policy of the government. Under present taxation system dividend income is tax-free income for shareholders whereas. The company has to pay tax on dividend given to shareholders. If the tax rate is higher, the company prefers to pay less in the form of dividend whereas. If the tax rate is low then the company may declare the higher dividend.
8. Access to Capital Market Consideration:
Whenever company requires more capital it can either arrange it by the issue of shares or debentures in the stock market or by using its retained earnings. Rising of funds from the capital market depends upon the reputation of the company.
If capital market can easily access or approach and there is enough demand for securities of the company then company can give more dividend and raise capital by approaching capital market, but if it is difficult for company to approach and access capital market then companies declare low rate of dividend and use reserves or retained earnings for reinvestment.
9. Legal Restrictions:
Companies’ Act has given certain provisions regarding the payment of dividends that can pay only out of current year profit or past year profit after providing depreciation fund. In case the company is not earning the profit then it cannot declare the dividend.
Apart from the Companies’ Act, there are certain internal provisions of the company that is whether the company has enough flow of cash to pay the dividend. The payment of dividend should not affect the liquidity of the company.
10. Contractual Constraints:
When companies take a long-term loan then financier may put some restrictions or constraints on the distribution of dividend and companies have to abide by these constraints.
11. Stock Market Reaction:
The declaration of the dividend has an impact on the stock market as an increase in dividend is taken as a good news in the stock market and prices of security rise. Whereas a decrease in dividend may have the negative impact on the share price in the stock market. So possible impact of dividend policy on the equity share price also affects dividend decision.
D. Liquidity Decision:
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity, and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity. It is important to invest sufficient funds in current assets. But since current assets do not earn anything for business, therefore, a proper calculation must do before investing in current assets.
Current assets should properly value and dispose of from time to time once they become non-profitable. Currents assets must use in times of liquidity problems and times of insolvency.