Decisions, decisions. Running an organization must involve taking thousands of decisions a day as you can imagine. The decisions that have to be taken with respect to the capital structure are known as Financing Decision. Let us learn a bit more about the types of financing decisions.
If carefully reviewed what constitutes a business, we will come to the conclusion that there are two things that matter, money and decision Without money, a company won’t survive and without decisions, money can’t survive. An administration has to take countless decisions in the lifetime of the company. Thus, the most important ones are related to money. The decisions related to money are called ‘Financing Decisions.’
There are three decisions that financial managers have to take:
- Investment Decision
- Financing Decision and
- Dividend Decision
These are also known as Capital Budgeting Decisions. A company’s assets and resources are rare and must be put to their utmost utilization. A firm should pick where to invest in order to gain the highest conceivable returns.This decision relates to the careful selection of assets in which funds will be invested by the firms. The firm puts its funds in procuring fixed assets and current assets. When choice with respect to a fixed asset is taken it is known as capital budgeting decision.
Factors Affecting Investment Decision
- Cash flow of the venture: When an organization starts a venture it invests a huge capital at the start. Even so, the organization expects at least some form of income to meet everyday day-to-day expenses. Therefore, there must be some regular cash flow within the venture to help it sustain.
- Profits: The basic criteria for starting any venture is to generate income but moreover profits. The most critical criteria in choosing the venture are the rate of return it will bring for the organization in the nature of profit for, e.g., if venture A is getting 10% return and venture В is getting 15% return then one must prefer project B.
- Investment Criteria: Different Capital Budgeting procedures are accessible to a business that can be utilized to assess different investment propositions. Above all, these are based on calculations with regards to the amount of investment, interest rates, cash flows and rate of returns associated with propositions. These procedures are applied to the investment proposals to choose the best proposal.
Financial decision is important to make wise decisions about when, where and how should a business acquire fund. Because a firm tends to profit most when the market estimation of an organization’s share expands and this is not only a sign of development for the firm but also it boosts investor’s wealth. Consequently, this relates to the composition of various securities in the capital structure of the company.
Factors affecting Financing Decisions
- Cost: Financing decisions are all about allocation of funds and cost-cutting. The cost of raising funds from various sources differ a lot. The most cost-efficient source should be selected.
- Risk: The dangers of starting a venture with the funds from various sources differ. Larger risk is linked with the funds which are borrowed, than the equity funds. This risk assessment is one of the main aspects of financing decisions.
- Cash flow position: Cash flow is the regular day-to-day earnings of the company. Good or bad cash flow position gives confidence or discourages the investors to invest funds in the company.
- Control: In the situation where existing investors need to hold control of the business then finance can be raised through borrowing money, however, when they are prepared for diluting control of the business, equity can be utilized for raising funds. How much control to give up is one of the main financing decisions.
- Condition of the market: The condition of the market matter a lot for the financing decisions. During boom period issue of equity is in majority but during a depression, a firm will have to use debt. These decisions are an important part of financing decisions.
Dividends decisions relate to the distribution of profits earned by the organization. The major alternatives are whether to retain the earnings profit or to distribute to the shareholders.
Factors Affecting Dividend Decisions
- Earnings: Returns to investors are paid out of the present and past income. Consequently, earning is a noteworthy determinant of the dividend.
- Dependability in Earnings: An organization having higher and stable earnings can announce higher dividend than an organization with lower income.
- Balancing Dividends: For the most part, organizations attempt to balance out dividends per share. A consistent dividend is given every year. A change is made, if the organization’s income potential has gone up and not only the income of the present year.
- Development Opportunity: Organizations having great development openings if they hold more cash out of their income to fund their required investment. The dividend announced in growing organizations is smaller than that in the non-development companies.
- Cash flow: Dividends are an outflow of funds. To give the dividends, the organization must have enough to provide them, which comes from regular cash flow.
- Shareholders’ Choices: While announcing dividends, the administration must remember the choices of the investors. Some shareholders want at least a specific sum to be paid as dividends. The organizations ought to consider the preferences of such investors.
- Taxes: Compare tax rate on dividend with the capital gain tax rate that is applicable to increase in market price of shares. If the tax rate on dividends is lower, shareholders will prefer more dividends and vice versa.
- Stock market: For the most part, an expansion in dividends positively affects the stock market, though, a lessening or no increment may negatively affect the stock market. Consequently, while deciding dividends, this ought to be remembered.
- Access to Capital Market: Huge and organizations with a good reputation, for the most part, have simple access to the capital market and, consequently, may depend less on retained earnings to finance their development. These organizations tend to pay higher dividends than the smaller organizations.
- Contractual and Legal Constraints: While giving credits to an organization, once in a while, the lending party may force certain terms and conditions on the payback of dividends in future. The organizations are required to guarantee that the profit payout does not abuse the terms of the loan understanding in any manner.
Certain arrangements of the Companies Act put confinements on payouts as profit. Such arrangements must be followed while announcing the dividends.
Solved Question for You
Question: Why do organization retain the earnings rather than distributing them? Because of
- legal constraints
- shareholders choice
- development opportunity for the organization
Answer. c. Because of development opportunity for the organization
Question: Explain the investment criteria factor affecting investment decision.
Answer. Different Capital Budgeting procedures are accessible to a business that can be utilized to assess different investment propositions. These are based on calculations with regards to the amount of investment, interest rates, cash flows and rate of returns associated with propositions. These procedures are applied to the investment proposals to choose the best proposal.