Business Studies Part I
Business Studies Part II

Financing Decisions

Financing Decision: This decision is about the quantum of finance to be raised from various long-term sources (short-term sources are studied in working capital management). It involves the identification of various available sources. The main sources of funds for a firm are shareholders funds and borrowed funds. Shareholders’ funds refer to equity capital and retained earnings. Borrowed funds refer to finance raised as debentures or other forms of debt. A firm has to decide the proportion of funds to be raised from either source based on their basic characteristics.

Interest on borrowed funds has to be paid regardless of whether or not a firm has made a profit. Likewise, borrowed funds have to be repaid at a fixed time. The risk of default on payment is known as a financial risk which has to be considered by a firm likely to have insufficient shareholders to make these fixed payments. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or repayment of capital. A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions, which may be debt, equity, preference share capital.

The financing decision is concerned with the decisions about how much funds are to be raised from which long-term source, i.e. by means of shareholders’ funds or borrowed funds. Shareholders’ funds include share capital, reserves, and surplus and retained earnings, whereas, borrowed funds include debentures, long-term loans, and public deposits.
Factors affecting financing decision:

  1. Cost: The cost of raising funds from different sources are different. A wise finance manager has option for the cheapest source of finance.
  2. Risk: The risk associated to each of the source is different. The source which involves least risk should be preferred.
  3. Floatation Cost: If the floatation cost, i.e. the expenses incurred in issue of debt is higher, the source of finance becomes less attractive.
  4. Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.
  5. Fixed Operating Cost: If a firm is having a higher fixed operating burden like payment of interests, premiums, salaries, rent, etc, then it should avoid financing through debt. This is because it will further increase the interest payment burden and the firm can reach an unfavorable position. However, if the firm has a lower operating cost, then the firm can borrow funds.
  6. Control Considerations: Issue of more equity may dilute shareholders’ control over the business. Therefore, a company afraid of a takeover bid may prefer debt to equity.
  7. State of Capital Market: If the stock market is rising, then it is easy to sell equity shares. But in a depressed capital market, the company has to opt for debt financing.
  8. Return on Investment (RQl): Return on Investment means the earnings of a company on its investments. It is an important criteria for deciding the type of funds to be sourced. When the RQI is more than the cost of debt, (i.e. interest to be paid on debt,) borrowed funds should be used. The reason being:
    (i) Interest paid on debt is deductible from profits while calculating tax liability.
    (ii) It increases the returns of the shareholders.
  9. Tax Rate: Since interest is a deductible expense, cost of debt is affected by tax rate. If the tax rate is higher, debt, financing becomes more attractive.
  10. Flexibility: Financing should be done in such a way, that it should be able to cater to additional requirements of funds in future. If a company uses its debt potential in full, it will lose flexibility to issue further debt, which might become necessary at some future point.
  11. Regulatory Frame Work: The Companies Act and SEBI guidelines must be observed while raising funds from the public. Government has laid down certain norms for debt equity ratio and ceilings on public deposits. Borrowings from banks and other financial institutions, require fulfillment of certain norms. Thus, the relative ease with which their procedures’ and norms can be met, has an impact on the choice of the source of finance.