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Question


What is meant by financing decision? State any four factors affecting the financing decision.
 


Solution

Financing decision is concerned with raising funds from which long-term sources, i.e., through shareholders funds or borrowed funds. Shareholders funds include share capital, reserves and surplus and retained earnings, whereas borrowed 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: 


Cost: The cost of raising funds from different sources are different. A wise finance manager opts for the cheapest source of finance.
Risk: The risk associated with each of the sources is different. The source which involves the least risk should be preferred.
Floatation Cost: If the floatation cost, i.e. the expenses incurred in an issue of debt is higher, the source of finance becomes less attractive.
Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.

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 unfavourable position. However, if the firm has a lower operating cost, then the firm can borrow funds.

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.

State of Capital Market: If the stock market is booming, then it is easy to sell equity shares. However, in a depressed capital market, the company has to opt for debt financing.

Return on Investment (RQl): Return on Investment means the earnings of a company on its investments. It is an essential criterion 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. 

Tax Rate: Since interest is a deductible expense, the cost of debt is affected by the tax rate. If the tax rate is higher, debt financing becomes more attractive.

Flexibility: Financing should be done in a way that should be able to cater to additional requirements of funds in future. If a company uses its debt potential fully, it will lose flexibility to issue further debt, which might become necessary at some future point.

Regulatory Frame Work: The Companies Act and SEBI guidelines must be observed while raising funds from the public. The government has laid down certain norms for debt-equity ratio and ceilings on public deposits. Borrowings from banks and other financial institutions require fulfilment 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.

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