Financing Decision: Meaning and Factors affecting Financing Decision
Financial Management is concerned with the management of the flow of funds and involves decisions related to the acquisition and application of funds in long-term and short-term assets. It is concerned with two aspects, they are procurement of funds as well as usage of finance.
Financial decision refers to the decision related to financial matters of a business firm. There are various financial decisions that a firm makes to maximize shareholders’ wealth. There are three major decisions that every financial management takes investment decision, financial decision, and dividend decision.
The financing decision is about the amount of finance to be raised from various long-term sources, this determines the various sources of finance, as well as it also provides the cost of each source of finance. The main sources of finance are:
- Shareholders’ Funds
- Borrowed Funds
The shareholders’ funds or owners’ funds consist of equity capital and retained earnings, whereas borrowed funds refer to finance raised as debentures or other forms of debt. The borrowed funds contain risk because they involve a commitment of fixed interest payment, although there will be loss in the organisation. On the other hand, owners’ funds have less risk because there is no such commitment regarding payment of dividends and replacement of the capital amount. Financing decisions involve analysing the risk and cost associated with each source of finance. Both sources have their own merits and demerits.
Burrowed funds are considered to be the cheapest source of finance because interest paid is a deductible expense for the calculation of tax liability. The cost of raising finance is known as floatation cost, and it is also considered while taking financing decisions. In this way, the financing decision is related to deciding how much amount is to be raised from each source. This decision determines the overall cost of capital and the financial risk of the enterprise.
Factors affecting Financing Decision
There are various factors that affect the financing decision. These are as follows:
- Cost: The cost of raising funds from different sources is different. A financing manager generally prefers the cheapest source of finance.
- Risk: The risk associated with different sources of finance is a different borrowed fund has a high degree of risk, as compared to the owners. The financial manager considers the risk involved with each source before taking a financing decision. In the case of equity, the risk is low, and in the case of debt, the risk is high.
- Floatation Cost: Floatation cost refers to the cost, which is involved in the issue of securities. In the case of equity, floatation cost is low, and in the case of debt, floatation cost is high. Some of the examples are underwriting commission, broken range stamp duty, etc. The firm prefers securities with the least floatation cost.
- Cash flow Position: A company with a strong cash flow position can take the advantage of debt because interest payment and re-payment of principal amount can be preferred by companies when there will be a shortage of cash.
- Level of Fixed Operating Costs: Owner’s fund is preferred by firms with a higher level of operating costs, like rent, salaries, insurance premiums, etc., because interests payment on debt will further add to the cost burden. And in case of moderate or low fixed operating costs, firms can go for borrowed funds.
- Control Consideration: The issue of more equity shares may lead to a dilution of management control over the business. Debt financing has no such implication. Companies that are afraid of taking over will prefer debt. It means if existing shareholders want to retain complete control of the company, then the debt should be preferred. However, if they don’t mind the loss of control, then the company may go for equity. So we can say that equity dilutes control, whereas debt doesn’t affect control.
- State of Capital Market: The condition of the stock market also helps in making the source of finance. In the case when the stock market is rising, during this period it is also easy to raise funds for the issue of shares because people are interested to invest in equity shares. But in case of a depressed market, company may face difficulties for issue equity shares.
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