Module 4: FINANCIAL DECISIONS

Learning Outcomes:

Studying this module should provide you with the strategic management knowledge needed
to:
 Understand the various types of financial decisions
 Describe the relationship of financial decisions
 Identify the various factors influencing financial decisions.

Introduction

Finance comprises of blend of knowledge of credit, securities, financial related legislations, financial
instruments, financial markets and financial system. As finance is a scarce resource, it must be
systematically raised form the cheapest source of funds and must be judiciously utilized for the
development and growth of the organization. Charles Gertenberg visualizes the significance of
scientific arrangement of records with the help of which the inflow and outflow of funds can be
efficiently managed, stocks and bonds can be efficiently marketed and the efficacy of the organization
can be greatly improved.

The financial manager in his new role, is concerned with the efficient allocation of funds. The
firm’s investment and financing decisions are continuous. The financial manager according to Ezra
Solomon must find a rationale for answering the following three questions.
1) How large should an enterprise be and how fast should it grow?
2) In what form should it hold its assets?
3) How should the funds required be raised? It is therefore clear from the above discussion
that firms take different financial decisions continuously in the normal course of business. Liquidity,
solvency, profitability and flexibility optimization goals and risk, would lead to reaping of wealth
maximization goal.

Financial Decisions – Types

Financial decisions refer to decisions concerning financial matters of a business firm. There are many
kinds of financial management decisions that the firm makers in pursuit of maximizing shareholder's
wealth, viz., kind of assets to be acquired, pattern of capitalization, distribution of firm's income etc.
We can classify these decisions into three major groups:

These choices can be divided into three categories:

1. Investment decisions
2. Financing decision.
3. Dividend decisions.
4. Liquidity decisions.

1. Investment Decisions / Capital Budgeting Decisions

Investment Decision relates to the determination of total amount of assets to be held in the firm, the
composition of these assets and the business risk complexities of the firm as perceived by the
investors. It is the most important financial decision. Since funds involve cost and are available in a
limited quantity, its proper utilization is very necessary to achieve the goal of wealth maximization.

The investment decisions can be classified under two broad groups; (i) long-term investment
decision and (ii) Short-term, investment decision. The long-term investment decision is referred to as
the capital budgeting and the short-term investment decision as working capital management. Capital
budgeting is the process of making investment decisions in capital expenditure. These are
expenditures, the benefits of which are expected to be received over a long period of time exceeding
one year.

The finance manager has to assess the profitability of various projects before committing the
funds. The investment proposals should be evaluated in terms of expected profitability, costs involved
and the risks associated with the projects. The investment decision is important not only for the
setting up of new units but also for the expansion of present units, replacement of permanent assets,
research and development project costs, and reallocation of funds, in case, investments
made earlier, do not fetch result as anticipated earlier.

2. Financing Decisions / Capital Structure Decisions

Once the firm has taken the investment decision and committed itself to new investment, it must
decide the best means of financing these commitments. Since, firms regularly make new investments,
the needs for financing and financial decisions are on going, Hence, a firm will be continuously
planning for new financial needs. The financing decision is not only concerned with how best to
finance new asset, but also concerned with the best overall mix of financing for the firm.

A finance manager has to select such sources of funds which will make optimum capital
structure. The important thing to be decided here is the proportion of various sources in the overall
capital mix of the firm. The debtequity ratio should be fixed in such a way that it helps in maximising
the profitability of the concern. The raising of more debts will involve fixed interest liability and
dependence upon outsiders. It may help in increasing the return on equity but will also enhance the
risk.

The raising of funds through equity will bring permanent funds to the business but the
shareholders will expect higher rates of earnings. The financial manager has to strike a balance
between anxious sources so that the overall profitability of the concern improves. If the capital
structure is able to minimise the risk and raise the profitability then the market prices of the shares
will go up maximising the wealth of shareholders.

3. Dividend Decision
The third major financial decision relates to the disbursement of profits back to investors who
supplied capital to the firm. The term dividend refers to that part of profits of a company which is
distributed by it among its shareholders. It is the reward of shareholders for investments made by
them in the share capital of the company. The dividend decision is concerned with the quantum of
profits to be distributed among shareholders.

A decision has to be taken whether ail the profits are to be distributed, to retain all the profits
in business or to keep a part of profits in the business and distribute others among shareholders. The
higher rate of dividend may raise the market price of shares and thus, maximise the wealth of
shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus
shares) and cash dividend.

4. Liquidity Decisions
Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in
most of the decisions. The finance manager always perceives / faces the task of balancing liquidity
and profitability. The term liquidity implies the ability of the firm to meet bills and the firm’s cash
reserves to meet emergencies.
Whereas the profitability means the ability of the firm to obtain highest returns within the
funds available. As said earlier, striking a proper balance between liquidity and profitability is an
ardous task. If a finance manager wants to meet all the bills, then profitability will decline similarly
where he wants to invest funds in short term securities he may not be having adequate funds to pay-
off its creditors. Lack of liquidity in extreme situations can lead to the firm’s insolvency.

Risk – Return Trade Off

Further where the company is desirous of mobilizing funds from outside sources, it is required to pay
interest at fixed period. Hence liquidity is reduced. A successful finance manager has to ensure
acceleration of cash receipts (cash inflows in to business) and deceleration of cash (cash outflows)
from the firm. Thus forecasting cash flows and managing cash flows are one of the important
functions a finance manager that will lead to liquidity. The finance manager is required to enhance his
professionalism and intelligence to ensure that return is optimized.

Return = Risk-free rate + Risk premium

Risk free rate is a compensation for time and risk premium for risk. Higher the risk of an action,
higher will be the risk premium leading to higher required return on that action. This levelling of
return and risk is known as risk return trade off. At this level, the market value of the company’s
shares should be the maximum. The diagram given below spells out the interrelationship between
market value, financial decisions and risk-return trade off.

Value of Firm – Risk Return

The finance manager tries to achieve the proper balance between, the basic considerations of 'risk and
return' associated with various financial management decisions to maximise the market, value, of the
firm. It is well known that "higher the return other things being equal, higher the market value; higher
the risk, other things being equal, lower the market alue'. In fact, risk and return go together.
It is quite evident from the aforesaid discussion that financial decisions have a great impact on
all other business activities. The modern finance manager has to facilitate making these decisions in
the most rational way. The decisions have to be made in such a way that the funds of the firms /
organizations are used optimally. The financial reporting system must be designed to provide timely
and accurate picture of the firm’s activities.

Relationship of Financial Decisions

The financial manager is concerned with the optimum utilization of funds and their procurement in a
manner that the risk, cost and control considerations are properly balanced in a given situation.
Irrespective of nature of decisions, i.e. investment decisions, financing or capital structure decisions /
dividend decisions all these decisions are interdependent. All these decisions are interrelated. All are
intended to maximize the wealth of the shareholders. An efficient financial manager has to ensure
optimal decision by evaluating each of the decision involved in relation to its effect on shareholders
wealth.

Factors Influencing Financial Decisions

There are innumerable factors that influence the financial decision. They are classified as external
factors and internal factors.

External factors
Capital structure
Capital market and money market
State of economy
Requirements of investors
Government policy
Taxation policy
Financial institutions / banks lending policy

Internal factors
Nature of business
Age of the firm
Size of the business
Extent and trend of earnings
Liquidity position
Working capital requirements
Composition of assets
Nature of risk and expected return.

Summary
Finance comprises of blend of knowledge of credit, securities, financial related legislations, financial
instruments, financial markets and financial system. As finance is a scarce resource, it must be
systematically raised form the cheapest source of funds and must be judiciously utilized for the
development and growth of the organization. Financial decisions refer to decisions concerning
financial matters of a business firm. There are many kinds of financial management decisions that the
firm makers in pursuit of maximizing shareholder's wealth, viz., kind of assets to be acquired, pattern
of capitalization, distribution of firm's income etc. We can classify these decisions into three major
groups:
1) Investment decisions,
2) Financing decision,
3) Dividend decisions, and
4) Liquidity decisions.

Investment Decision relates to the determination of total amount of assets to be held in the
firm, the composition of these assets and the business risk complexities of the firm as perceived by the
investors. The financing decision is not only concerned with how best to finance new asset, but also
concerned with the best overall mix of financing for the firm. A finance manager has to select such
sources of funds which will make optimum capital structure. The dividend decision is concerned with
the quantum of profits to be distributed among shareholders. A decision has to be taken whether ail
the profits are to be distributed, to retain all the profits in business or to keep a part of profits in the
business and distribute others among shareholders. The higher rate of dividend may raise the market
price of shares and thus, maximize the wealth of shareholders. The term liquidity implies the ability of
the firm to meet bills and the firm’s cash reserves to meet emergencies. Whereas the profitability
means the ability of the firm to obtain highest returns within the funds available. As said earlier,
striking a proper balance between liquidity and profitability is an ardous task. The finance manager
tries to achieve the proper balance between, the basic considerations of 'risk and return' associated
with various financial management decisions to maximize the market, value, of the firm. The financial
manager is concerned with the optimum utilization of funds and their procurement in a manner that
the risk, cost and control considerations are properly balanced in a given situation.

Review Questions
1) What is meant by financial decision?
2) Explain investment decision.
3) Explain liquidity Vs. Profitability?
4) Discuss the significance of various financial decisions.
5) What is meant by liquidity decision?
6) Explain risk-return trade off.
REFERENCES:
Khan MY, Jain PK, BASIC FINANCIAL MANAGEMENT, Tata McGraw Hill, Delhi , 2005.
Chandra, Prasanna,. FINANCIAL MANAGEMENT, Tata McGraw Hill, Delhi.
Bhabatosh Banerjee, FUNDAMENTALS OF FINANCIAL MANAGEMENT, PHI, Delhi, 2010
Chandra Bose D, FUNDAMENTALS OF FINANCIAL MANAGEMENT, PHI, Delhi, 2010
Preeti Singh, FUNDAMENTALS OF FINANCIAL MANAGEMENT, Ane, 2011