The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of funds required for the investment decisions.

Sources of Financing Decision

The financing decision involves two sources from where the funds can be raised:

  • Using a company’s own money, such as share capital, retained earnings
  • Borrowing funds from the outside in the form debenture, loan, bond, etc.

The Financial Management can be broken down in to three major decisions or functions of finance. They are: (i) the investment decision, (ii) the financing decision and (iii) the dividend policy decision.

Types of Financing Decision

  1. Investment Decision
  2. Financing Decision
  3. Dividend Decision

1. Investment Decision

The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets as per their duration of benefits, can be categorized into two groups: (i) long-term assets which yield a return over a period of time in future (ii) short-term or current assents which in the normal course of business are convertible into cash usually with in a year. Accordingly, the asset selection decision of a firm is of two types. The investment in long-term assets is popularly known as capital budgeting and in short-term assets, working capital management.

Investment decisions encompass wide and complex matters involving the following areas:

  • Cost of Capital
  • Cost of Capital
  • Measuring Risk
  • Management of Liquidity and current assets
  • Expansion and contraction involving business failure and re-organisations.
  • Buy or hire or lease an asset.

1. Financing Decision

In this decision, the manager needs to see the sources from where he can arrange maximum funds with minimum rate of interest and for longer period of time.

The available options could be whether to take it from banks or financial institutions, secondly the company could issue their bonds for the public, thirdly, there are debenture holders who lend money for a comparatively larger period of time but when you are supposed to return the share of profit, then very first preference is supposed to be given to these debenture holders.

Fourthly, the company can issue their shares, could be preferant or equity shares. Shares specifically equity shares are considered to be the least safe ones and even at the time of balance sheet, equity share holders are given the last preference.

Factors influencing Financing decisions:

i. 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.

ii. 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

iii. 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.

iv. 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. 

3. Dividend Decision

This is third major financial decision for an finance manager to decide whether the firm should distribute all their profits, or hold them, distribute a portion and keep some part with the company.

Most profitable companies pay cash dividends on regular basis and along with these, additional shares called as bonus shares are also issued for the present shareholders.

Factors Influencing Dividend Decisions

i. Earnings:

Returns to investors are paid out of the present and past income. Consequently, earning is a noteworthy determinant of the dividend.

ii. Dependability in Earnings:

An organization having higher and stable earnings can announce higher dividend than an organization with lower income.

iii. 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.

iv. 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.