This article throws light upon the top three types of financial decisions. The types are: 1. Investment decisions 2. Financing decisions 3. Dividend decisions.
Type # 1. Investment 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 complexions of the firm as perceived by its investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, its proper utilisation is very necessary to achieve the goal of wealth maximisation.
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.
Short-term investment decision, on the other hand, relates to the allocation of funds as among cash and equivalents, receivables and inventories. Such a decision is influenced by tradeoff between liquidity and profitability.
The reason is that, the more liquid the asset, the less it is likely to yield and the more profitable an asset, the more illiquid it is. A sound short-term investment decision or working capital management policy is one which ensures higher profitability, proper liquidity and sound structural health of the organisation.
Type # 2. Financing 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 ongoing.
Hence, a firm will be continuously planning for new financial needs. The financing decision is not only concerned with how best to finance new assets, 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 various 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.
Type # 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 all 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.