Financial decisions

The essentials

Financial management involves three broad decisions. The investment decision is about where to invest funds. The financing decision is about how much to raise and from which sources. The dividend decision is about how much of the profit to distribute to shareholders and how much to retain.

Key points

• Investment decision: long-term investment decisions are also called capital budgeting decisions (for example, buying a new machine or opening a new plant); short-term decisions relate to working capital. Factors: cash flows of the project, rate of return, and investment criteria involved.
• Financing decision: choosing between owners' funds (equity, retained earnings) and borrowed funds (debentures, loans). Debt is generally cheaper because interest is tax-deductible, but it is riskier because interest must be paid regardless of profit. Factors: cost, risk, floatation costs, cash flow position, level of fixed operating costs, control considerations and the state of the capital market.
• Dividend decision: factors include amount of earnings, stability of earnings, stability of dividends, growth opportunities (growing firms retain more), cash flow position, shareholders' preference, taxation policy, stock market reaction, access to the capital market, and legal and contractual constraints.

Exam tips

• A company with many growth opportunities usually pays lower dividends and retains more profit.
• A firm whose owners fear losing control will prefer debt over issuing new equity shares.

Common mistakes

• Thinking debt is the safest source because it is cheaper. It is cheaper but increases financial risk.
• Treating capital budgeting as a financing decision. It is a long-term investment decision.