FM

UNIT-II
The Financing Decision is a crucial decision that is to be made by the financial
manager, the decision is about the financing-mix of an organization. Financing
Decision is focused on the borrowing and allocation of funds required for the
investment decisions of the firm. We will learn in detail about these various
financing decisions in the upcoming section.

The financing decision comes from two sources from where the funds can be
raised – first is from the company’s own money, such as the share capital,
retained earnings. Second is from borrowing funds from the outside the corporate
in the form debenture, loan, bond, etc. The objective of the financial decision is to
balance an optimum capital structure.
Types of Financial Decisions?
Basic Financial Decisions that financial managers need to take:
 Investment Decision
 Financing Decision and
 Dividend Decision
Investment Decision
Also known as the Capital Budgeting Decisions. A company’s assets and
resources are very rare and thus must be put to use with much analysis. A firm
should pick those investments where he can gain the highest conceivable
returns. Investment decision involves careful selection of the assets where funds
will be invested by the corporates.
Financing Decision
Financial decision is the utmost important decision which is to be made by
business individuals. These are wise decisions indeed that are to be chalked out
with proper analysis. He decides 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 firm but also to boost the investor’s wealth.
Dividend Decision
Dividend decisions relate to the distribution of profit that are earned by the
organization. The main criteria in this decision are whether to distribute to the
shareholders or to retain the earnings. Dividend decisions are affected by the
earnings of the business, dependency on earnings.
Importance of Financial Decision Making
1. Long-term Growth and Effect:
Financial decisions are concerned with the long-term use of assets. These
assets are very helpful in the process of production. Profit is also earned
by selling the goods that are produced. This can, therefore, be accurate
 decisions. The greater the growth of business in the long run, the more
effective the decision needs to be. In addition to that, these affect the
future prospect of the business.
2. Large Amount of Funds Involved:
Funds are the base of this business decision. Decisions regarding the fixed
assets are included in the context of capital budgeting. Huge capital is
invested in these assets. If these decisions turn out to be a flaw, then it will
cause heavy loss of capital which is indeed a scarce resource.
3. Risk Involved:
Capital budgeting decisions come with risks. There are two reasons for the
risk factor to be involved in it. First, these decisions are analysed for a long
period, and thus the expected profits for several years are to be anticipated
which even lead to fluctuations. These are human estimations which may
turn out to be wrong. Secondly, as a heavy investment is involved, it is
very difficult to change the decision once it has been taken.
4. Irreversible Decisions:
Nature of these decisions is irreversible, once taken it cannot be reformed.
For instance, if soon after setting up a sugar mill, the owner thought of
changing it, then the old machinery used for the purpose and other fixed
assets will have to be sold at a loss. In doing this, the heavy loss will have
to be incurred by the owner.

actors Affecting Investment Decision

 Cash flow of the venture: If an organization starts a venture it begins to
invest a large amount of capital at the initial stage. Though, the
organization expects at least a source of income to meet daily expenses.
Hence, within the venture, there must be some regular cash flow to
sustain.
 Profits: The fundamental criteria to start a venture is to generate income
but moreover profits. The most crucial criteria in choosing the venture
involve the rate of return for the organization with respect to its profit
nature. For example: if venture A gets 10% return and venture В gets 15%
return then project B must be preferred.
 Investment Criteria: Various Capital Budgeting procedures are used for a
business to assess various investment propositions. Most importantly, they
are based on calculations with respect to investment, interest rates, cash
flows, and rate of returns associated with propositions. These are applied
to the investment proposals to make a decision on the best proposal.
Factors Affecting Financing Decisions
 Cost: Financing decisions are based on the allocation of funds and cost-
cutting. The cost of fundraising from different sources differs a lot and the
most cost-efficient source should be chosen.
 Risk: The dangers of starting a venture with funds differ based on various
sources. Borrowed funds have a larger risk compared to equity funds.
 Cash flow position: Cash flow is the daily earnings of the company. A
good cash flow position gives confidence to the investors to invest funds in
the company.
 Control: In this case where existing investors hold control of the business
and raise finance through borrowing money, however, equity can be
utilized for raising funds when they are prepared for diluting control of the
business.
 Condition of the market: The condition of the market plays a major role in
financing decisions. Issuance of equity is in majority during the boom
period, but debt of a firm is used during a depression.

Cost of Capital:Cost of capital is the minimum rate of return or

profit a company must earn before generating value. It's
calculated by a business's accounting department to determine
financial risk and whether an investment is justified.
Components of Cost of Capital
There are three factors to the cost of capital explained below:

Zero Risk Return

It talks about the expected rate of return when a project involves no financial or
business risks.

Premium for the Business Risk

Business risk is determined by the capital budgeting decisions that a firm takes for
its investment proposals. So, if a firm selects a project that has more than normal
risk, then it is obvious that the providers of capital would require or demand a
higher rate of return than the normal rate.

Thus the premium factor plays an important role here as it increases the Cost of
Capital. But how much premium? it’s up to the firm’s project selection decision
which alienates with the firm’s goal and objectives and how badly they want the
project to increase their market value.

Premium for the Financial Risk

Financial risk is associated with the capital structure pattern of the firm. Here, the
premium finds its way to the picture depending on the volume of debts the firm
owes. The higher the debt capital, the more is the risk compared to a firm that has
relatively low debts.

Cost of Specific sources of capital:

The cost of each component of capital is known as specific cost of capital. A firm raises
capital from different sources such as equity, preference, debentures, etc. Specific cost
of capital is the cost of equity share capital, cost of preference share capital, cost of
debentures, etc., individually.
Various types of cost of capital :
i. Explicit Cost of Capital:
Explicit cost of any source may be defined as the discount rate that
equates the present value of the funds received by a firm with the
present value of expected cash outflows.
ii. Implicit Cost of Capital:
The implicit cost may be defined as the rate of return associated with
the best investment opportunity for the firm and its shareholders that
will be foregone if the project under consideration by the firm is
accepted. If a firm retains its earnings, implicit cost will be the income,
the shareholders could have earned if such earnings would have been
distributed and invested by them elsewhere.

iii. Specific Cost of Capital:

The cost of each component of capital is known as specific cost of capi-
tal. A firm raises capital from different sources such as equity,
preference, debentures, etc. Specific cost of capital is the cost of equity
share capital, cost of preference share capital, cost of debentures, etc.,
individually.
iv. Weighted Average Cost of Capital:
The weighted average cost of capital is the combined cost of each
component of funds employed by the firm. The weights are the
proportion of the value of each component of capital in the total
capital.

v. Marginal Cost of Capital:

Marginal cost is defined as the cost of raising one extra rupee of
capital. It is also called the incremental or differential cost of capital. It
refers to the change in overall cost of capital resulting from the raising
of one more rupee of fund. In other words, it is described as the
relevant cost of new funds required to be raised by the company.