Explained: Financial Decision making in a Firm

A firm is a for-profit business organization—such as a corporation, limited liability company (LLC), or partnership—that provides manufacturing, distribution, marketing, and professional services. Financial decisions are the decisions that business organizations need to make about finances.

There are three basic types of financial decisions companies have to make regarding;

* Investment,

*Financing, and

* Dividend.

Investments:

Investment decisions pertain to how executives like to invest in various securities, instruments, current assets, capital assets, etc. to gain the highest conceivable returns. An integral part of financial decisions on investments is the consideration of the cost of capital, which companies must take into account. If the choice is taken concerning a fixed asset it is called a capital budgeting decision. For any such capital investment worth undertaking, the expected return on capital must be greater than the cost of capital i.e. weighted average cost of capital (WACC). Further, the cost of capital is an important ingredient in the valuation of a company by investors. These decisions are considered more important than financing and dividend decisions.

Financing:

Financing decisions refer to the decisions that a business organization needs to take regarding what proportion of equity and debt capital to have in their capital structure. The relation of financing decisions is to raise equity while reducing debt as much as possible. Often, they are taken in light of the investment decisions. This plays a very important role vis-a-vis financing its assets, investment-related decisions, and shareholder value creation. The management has to chalk out with proper analysis deciding when, where, and how should the business acquire the fund. An organization’s increase in share is not only a sign of development for the business but also to boost the investor’s wealth. These decisions must be taken continuously as the business needs funds regularly. Financing decisions should not be very rigid to allow room for maneuver if an emergency arises or the economic situation changes suddenly.

Dividend Decision:

Dividends decisions relate to the distribution of profits earned by the organization. The major decision on dividend distribution is whether to retain the earnings profit or to distribute it to the shareholders.  The decision involved here is how much of the profit earned by the company after paying the taxes is to be distributed to the shareholders.  However, rewards must be given to investors in return for their investment in the company’s stock. Giving too little can cause a loss of trust and confidence in shareholders in the organisation. However, giving too much would reduce the profit margin of the organisation. So, an optimum balanced dividend decision must be taken in this situation.

The financial decisions related to the above matters are of great significance for the organization’s financial comfort. Factors like expenditure management, day-to-day capital management, assets-liability management, raising funds; investment, etc. are affected by financial decisions. Financing decisions also refer to the decisions that firms need to take regarding what proportion of equity and debt capital to have in their capital structure. Undertaking efficient financial decisions can lead to immense revenue over a long-term period.

Factors Affecting Investment Decisions:

Capital budgeting-

Capital Budgeting (also known as investment appraisal) is the process of project appraisal to decide whether the big investment in such a long-term project is worth pursuing. Long-term investment may be needed for a company for technology upgrades, purchase of new machinery, expansion programmes, planning creation of new products, research, and  development unit, etc. The project appraisal will look into various factors involved in the budgeting such as the calculation of initial cash investment and the number of years it takes for a project’s cash flow to pay back the initial cash investment, future accounting profit, Net Present Value (NPV), Benefit to Cost Ratio,    Internal Rate of Return (IRR), Accounting Rate of Return, calculation of discount rate/discount factor and Assessment of risk, etc. A project is passed for implementation only if the assessment satisfies that the proposed project adds value to the company in terms of the rate of return on the cost of capital. Read:

The risks involved in capital budgeting:

There are numerous risks involved in a venture which are taken into account while taking a business decision. Different techniques are used to evaluate the probable risks through sensitivity analysis, scenario analysis, and break-even analysis among others. In capital budgeting, the following three types of risks viz. stand-alone risk, market risk and corporate risk are invariably assessed.

Stand-Alone Risk: The risks associated with the new projects are determined separately from the company’s other assets. The evaluation of investment proposals must occur by techniques of capital budgeting. This means considering factors like rate of return, interest rate, investment amount, etc.

Cash flows of the project- A proper estimation must be made of the expected cash receipts and payments during the entire tenure of an investment proposal.

Rate of return- The expected returns from an investment proposal must be considered.

It is essential to consider several other factors like understanding risk tolerance, return expectations, investment horizon, and e prevailing tax laws in the country. Read: WHAT IS CAPITAL BUDGETING AND CASH BUDGET SYSTEM?

Factors Affecting Financing Decision:

Financing decisions are strategic choices that companies make to determine how to raise capital to fund investments. They involve deciding what proportion of equity and debt capital to have in the capital structure. Factors that affect financing decisions include:

Cost of capital: The cost of raising funds varies from one source to another. Different sources of funds have different costs. Lower financing costs are preferred by managers.

Cash flow position- A positive cash position can make it easier for companies to get better terms for financing loans.

Flotation cost- This is the cost involved in issuing securities like expenses on the prospectus, the fee of underwriting, and the commission or brokerage.

Risk tolerance: The risk associated with various financing sources is not the same. Borrowed funds involve more risk than the owner’s fund as interest. Risk tolerance is the amount of loss an investor is prepared to handle while making an investment decision.

Market conditions: The market conditions in which the business operates.

Regulatory environment: The regulatory environment in which the business operates.

Economic condition- Finances can be raised easily during an economic boom, while a recession makes it hard to raise finances.

Factors Affecting Dividend Decision:

There are various factors affecting the dividend decisions of firms carefully assessed. Profitability, cash flow, financial health, growth options, industry norms, legal and regulatory needs, and shareholder preferences all play an important role in shaping dividend policies

Dependability of earnings: – Returns to investors in the form of dividends are paid out of the present and past income. An organization having higher and stable earnings can announce a higher dividend than an organization with lower income. Consequently, earning is a noteworthy determinant of the dividend.

Dividend stability: – Dividend stability is a company’s policy to provide a steady dividend payment to shareholders, regardless of market volatility. The goal is to ensure a predictable payout that investors value.

Taxation policy: – A high dividend tax would mean that organisations would generally do lower dividend payouts. The situation would be reversed if tax rates were lower.

Growth prospects: – If the estimated growth prospects of the organisation are good shortly, the number of dividends will be low. This is because reinvesting dividends can be a powerful way to grow investment over time, allowing investors to benefit from compounding.

Cash flow: – When declaring dividends, an organisation must ensure sufficient cash is available. As such, the organisation’s cash flow position is a crucial factor to consider.

Development Opportunity: – Organizations have 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 non-development companies.