Financing Decision

Financing Decision

A financing decision answers two fundamental questions: how much finance should a firm raise, and from which long-term sources should it raise it? Short-term sources are handled separately under working capital management. The core of this decision lies in choosing between two broad categories of funds — shareholders’ funds and borrowed funds.

Shareholders’ funds consist of equity capital and retained earnings. Borrowed funds come from debentures or other forms of debt. The firm must decide the proportion of funds to raise from each source, and this choice is driven by the basic characteristics of each.

Borrowed funds carry a fixed obligation. Interest must be paid regardless of whether the firm has earned a profit, and the principal must be repaid at a fixed time. The risk that a firm may not have enough earnings to meet these fixed payments is called financial risk. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or the repayment of capital. A firm therefore needs a judicious mix of both debt and equity.

The actual sources available for financing include debt, equity, preference share capital, and retained earnings. Each source has a different cost. Debt is generally considered the cheapest source, and the tax deductibility of interest makes it even cheaper. However, the associated risk also differs — interest on debt and repayment of principal are compulsory, whereas dividend on equity shares is not. The overall financial risk of the firm depends on the proportion of debt in the total capital.

Raising funds also involves a cost called floatation cost — the expense of issuing securities. This must be considered while evaluating different sources.

Thus, the financing decision determines both the overall cost of capital and the financial risk of the enterprise.

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Factors Affecting Financing Decisions

Several factors influence the choice between debt and equity. The important ones are:

1. Cost: Different sources have different costs. A prudent financial manager normally opts for the cheapest source.
2. Risk: The risk associated with each source is different. Debt carries higher financial risk because of fixed interest and repayment obligations.
3. Floatation Costs: Higher floatation costs make a source less attractive.
4. Cash Flow Position of the Company: A stronger cash flow position makes debt financing more viable than funding through equity, because the firm can comfortably meet interest and repayment obligations. …