The Financing Decision is a crucial decision made by the financial manager relating to the financing-mix of an organization. Financial decisions are concerned with the borrowing and allocation of funds required for investment decisions. These decisions are essential to the continuity of the business over the long term. It includes decisions regarding the magnitude of funds to be invested to accomplish its goals, kind of assets to be acquired, the capital structure, the pattern of distribution of the firm’s income. The nature of financial decisions varies from one firm to the other. It may also be different for the same firm over a period of time.

There are two sources for funds for financing the company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form of debentures, loans, bonds, etc.

External Factors Affecting Financial Decisions:

External factors affecting financial decisions are the environmental factors within which a firm has to operate. These factors are beyond the control and influence of the management. But the finance manager can take the best decision considering all these factors.

State of the Economy:

The economic condition of the country greatly influences the financing decision. In times of prosperity when investors are ready to invest more and more savings. Thus the firm can raise the required funds from the market easily. In such conditions expectations of investors are more hence payouts will be more. Hence in such environment raising funds by the issue of debentures is a better choice.

In times of depression raising fund is difficult. Hence in such conditions, internal financing is a better choice. For such eventualities, the firm should have hefty reserves. The time when the economy is showing recovery from depression is the best time for raising funds. The finance manager should not miss the chance of exploiting opportunities.

Structure of Capital and Money Market:

If a country has good and developed capital and money market, then it is easy for the finance manager to raise the required funds for long-term and short-term from different sources. It helps the finance manager’s bargaining power and also helps him to raise the funds at any period of time.

Government Policy:

All the decisions taken by the finance minister should be according to the law of the land. The finance manager should only those projects which are allowed by the government. During the issue of equity or any other financial instrument guidelines issued by government institutions (SEBI in India) should be followed.

Taxation Policy:

Tax is a large chunk of outgoing money from the business. Hence it influences financial decisions. The tax policy is declared by the government. The government may issue tax holidays for important projects like infrastructure projects. (roads, bridges, airports, rails, ports, telecommunication, etc.). The finance manager should take advantage of such policies.

The method of depreciation (straight line, diminishing balance, annuity) should be selected judiciously to reduce the tax burden.

Tax liability also depends on the method of valuation of inventory. The two methods used are LIFO (last in first out) and FIFO (first in first out). The finance manager has to decide on the method in advance.

The interest on the debt is a tax-deductible expenditure while dividends are considered for the tax deduction. Hence the debt is a better option to save tax.

Investor’s Requirements:

Investors may have a varying degree of safety, liquidity and profitability notions. The psychology of investor changes as per their economic conditions and the economic condition of society as a whole. In this global era, world economic condition also impacts the investor’s psyche. Financial decisions depend on their requirements. Conservative and liquidity conscious investor prefers equity investment than other instruments. Dividend payout policy of the firm impacts an investor’s decision to invest money.

The Policy of Financial Institutions:

Every financial institution has its own policy of lending. A particular financial institution may be liberal for granting finance to large projects but not keen to finance a small project. Such institution lay more conditions and regulations on finance to small projects. Hence the finance manager has to consider the policy of the institution. The terms and conditions of a financial institution should be studied carefully and only accepted when they are not affecting the objectives and strategy of the firm. Sometimes the capital structure of the firm is required to be changed to acquire the finance.

Internal Factors Affecting Financial Decisions:

Internal factors affecting financial decisions include nature of the business, the size of business, expected return, the cost and risk involved, the asset structure of the business, the structure of ownership, the expectations of investors, the age of the firm, the liquidity in company funds and its working capital requirements, and the attitude of the management.

Nature of the Business:

In manufacturing and public utility business, the most of the fund required is utilized for fixed assets while in trading firms it is mainly utilized for current assets. The fund requirements of capital goods industries are more than consumer good industries.

The firms engaged in the production of staple goods (Consumer goods (such as bread, milk, paper, sugar) that are bought often and consumed routinely), have stability in their level of earnings. Such firms can rely on debt for acquiring additional funds for the business. Because they have constant cash flow, irrespective of economic conditions. Similarly, large manufacturing units producing goods which have continuous demand can rely on debt for acquiring additional fund.

The firms producing seasonal goods or whose demand oscillates, avoid the burden of fixed charges.

Size of the Business:

The fund requirements depend on the size of the business. Large size businesses require large funds for buying assets and automated machinery. They require fund for constructing buildings and plants. Small-scale business can continue with leased assets. The credit position in the financial market of larger business may be more than the smaller business. The small business owners are hesitant about going public. They arranged their fund sources among close circles. Large businesses find it easier to procure needed funds from different sources of capital and money markets.

The number of shareholders in small business is less and hence can be persuaded very easily for a particular policy. In large businesses, due to a large number of stakeholders, it is difficult to pursue a particular policy.

Age of the Firm:

New firms find it very difficult to raise finance from investors due to the relatively greater risks involved. For raising finance the new firms have to approach underwriters and stockbrokers and pay them higher commission and brokerage for sale of their securities. Thus the debt-equity ratio of new firms is small. The fund may be raised by issuing debentures but it may lead to a condition where a large part of income might be used to pay the interest on loans. A small amount might be available for dividend payout and for keeping reserves.

older companies which have proved themselves in their past and on the basis of their credibility may not face a major problem in raising funds from the market. Such firms usually float debentures for their long-term financial requirements. They also utilize a part of the reserves for covering their additional financial needs. Thus the debt-equity ratio is higher in the case of old businesses.

Probabilities of Regular and Steady Earnings:

If the cash flow is continuous and showing a gradual increase then the reliance on debt may be desirable. If the cash flow is irregular but the yearly average is constant and growing then preferential shares can be issued to raise funds. When earnings of the firm fluctuating violently in the past and the future earnings cannot be predicted with reasonable certainty, then debt path should be avoided. In such cases issue of common stock must be preferred.

Firms that are in the growth stage of their cycle typically finance that growth through debt, to grow faster. But the revenues of growth firms are typically unstable and unproven. Hence if the growth rate is not sustained for a longer period, the firm may come into a debt trap.

Liquidity Position of the Firm:

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Before taking the dividend decision the finance manager should consider the funds required to meet maturing obligations, working and fixed capital requirements. if a company has sufficient amount of cash resources in hand at the time when some loans taken in the past are due, then the finance manager should conserve cash to meet the past obligations and the dividend policy should be changed accordingly.

Working Capital Requirement:

If a large sale has been done on credit then there may be a temporary cash crunch, which may affect the requirement of working capital. In such a case, the working capital requirements of the firm may be so immediate that may affect conservative dividend policy.

Management Style:

Management style or attitudes depends on the concern of control of the business and risk. In such cases, the management raises funds by issuing debentures and preferential stock which do not affect the controlling position of the management in the firm. But it increases the debt of the firm. Thus it is better to sacrifice control by infusing some additional equity financing than the risk of all control to creditors due to additional debt.

In a conservative management style, the firm may go for equity financing rather than debt financing. Aggressive management may try to grow the firm quickly, using significant amounts of debt to increase profits. 

Previous Topic: Profit and Wealth Maximization

Management > Financial Management > Functions of Financial Manager: Financial Decisions

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Financial management is concerned with procurement and use of funds.   The main objective of Financial management is to ensure the maximization of the economic welfare of its shareholders. The maximization of economic welfare means maximization of wealth of its shareholders. Shareholder’s wealth maximization is reflected in the market value of the firm’s shares.

Profit Maximization:

Profit maximization is the objective of any economic activity. The performance and efficiency of a firm are evaluated in terms of profitability. Every business has to earn profit to cover its costs and provide funds for future growth.  Without profit, no business can survive. Profit provides a cushion for any random risk arising at any time.

Points in Favour of Profit maximization:

• It is a barometer of the performance and efficiency of a firm.
• It covers the cost of running a business.
• It provides a fund for future growth.
• Without profit, a business cannot survive.
• It provides support in emergencies.

Criticism on Profit Maximization:

• The concept of profit lacks clarity. profit is neither defined precisely nor correctly. What does profit mean? Is it profit after tax or before tax? Is it operating profit or net profit available to shareholders? Is it a long-term profit or a short-term profit? Differences in interpretation of the concept of profit thus expose the weakness of profit maximization.
• Profit maximization is the traditional and narrow approach, which aims at maximizing the profit of the firm.
• Due to the sole goal of profit maximization, there may be the exploitation of labours and consumers. It may lead to immoral marketing and killing of the competition.
• Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings.  It treats all earnings as equal when they occur in different periods. It does not differentiate between the profits of the current year with the profits to be earned in later years. Similarly, it does not the difference for the firm between the cash received today and same cash received after one year.
• It does not take into consideration the risk of the prospective earnings stream. It fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk, environmental risk or risky projects of the firm. Risks may be internal or external which will affect the overall operation of the firm.
• The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization.
• Profit maximization has the above-mentioned drawbacks, but still, it is considered important because continued profit do wealth maximization for the shareholders.

Wealth Maximization:

The objective of wealth maximization is a universally accepted concept in the field of business. The term wealth means shareholder’s wealth. A shareholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. The individual shareholder can use this wealth to maximize his individual utility.  Thus wealth maximization is maximizing shareholder’s utility.

Wealth maximization objective helps in increasing the market value of shares. The share’s market price is a performance index of the progress of a firm.  It also indicates the performance of management on behalf of the shareholder.

Through the process of discounting, wealth maximization takes care of the quality of cash flow. The risks that are associated with cash flow are adequately reflected when present values are taken to arrive at the net present value of any project.

Points in favour of Wealth Maximization:

• It overcomes the limitations of the policy of profit maximization.
• It serves the interests of suppliers, financers, employees, management, consumers, and society.
• The concept of wealth maximization is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation.
• Wealth maximization considers the time value of money. Time value of money translates cash flow occurring at different periods

Criticism on Wealth Maximization:

• It is a prescriptive idea. The objective is not descriptive of the policies the firm has to adapt to achieve wealth maximization. The policies of different firms may be different.
• The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.
• Wealth maximization concept is useful for equity shareholders and not to debenture holders and society.

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