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Financial Management - Finance – An Introduction

Financial Decisions – Types

   Posted On :  19.06.2018 10:33 pm

Financial decisions refer to decisions concerning financial matters of a business firm.

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 maximising shareholder’s wealth, viz., kind of assets to be acquired, pattern of capitalisation, distribution of firm’s income etc. We can classify these decisions into three major groups:

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 maximasation.
 
The investment decisions can be classified under two broad groups; (i) long-term investment decision and (ii) Short-term, in 
vestment 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 debt-equity 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 profitability aims to achieve the goal of higher returns. As said earlier, striking a proper balance between liquidity and profitability is a difficult task. Profitability will be affected when all the bills are to be settled in advance. Similarly, liquidity will be affected if the funds are invested in short term or long term securities. That is the funds are inadequate to pay-off its creditors. Lack of liquidity in extreme situations can lead to the firm’s insolvency.

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