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: