Financing Decisions

Financing decisions are concerned with the amount of finance to be raised from various long-term sources of funds like, equity shares, preference shares, debentures, bank loans etc and its impact on the capital structure of the organisation.

It is one of the three main decisions of Financial Management – Investment decisions, Financing decisions and Dividend decisions.

Factors affecting financing decisions

While making financing decisions, one must focus on the composition of funds from various long-term sources. These decisions involve:

1. Decision whether or not to use a combination of ownership and borrowed funds.
2. Determining the ratio in which ownership and borrowed funds should be kept.

A firm should have an appropriate mix of debt as well as equity.

• The disadvantage of having Debt is that it involves Financial Risk which is the risk of default on payment or interest on borrowed funds and the repayment of principle amount
• However, tax benefit on interest payments of the debt reduces its cost, making it cheaper than equity.
• In order to avail the benefits of debt wisely, the cost of debt should be less than the rate of return on the capital.
• Shareholders’ funds have no fixed commitment in the aspects of repayment of capital or payment of returns.

Factors to be considered to make financing and capital structure decisions are listed below-

1. Interest/dividend pay-out: Debt involves compulsory interest payments whereas there is no compulsion to pay dividend to equity shareholders. However, the company should also keep its dividend policy in mind, in case they prefer paying dividends in order to retain their shareholders.
2. Tax deductibility– Interest payments are tax deductible which reduces its overall cost.
3. Dilution of control– In case the existing shareholders want to retain the complete control of business then finance can be raised through borrowed funds or preference shares but when they are ready for dilution of control over business, equity shares can be used for raising finance.
4. Risk and floatation costs: More risk is associated with borrowed funds as compared to owner’s fund as interest is paid on it and it is also repaid after a fixed period of time or on expiry of its tenure. The cost involved in issuing securities such as broker’s commission, underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the flotation cost, less attractive is the source of finance.
5. Feasibility & Cash Flow position: In case the cash flow position of a company is good enough then it can easily use borrowed funds.
6. Payment schedule: In case the company wants to go for debt, then the payment schedule, tenure and total costs (principal+interest) should be analysed and compared with other options. Longer the schedule, greater the interest so in case the schedule is too long, the terms should be modified or other financing options can be considered.

Different options and compositions of debt and shareholder’s fund can be analysed to find the one with the lowest weighted average cost (WACC). This way the company enjoys the tax benefit advantage of debt and non-compulsion of dividend payments advantage of equity.

However, it is important to analyse costs after factoring in the time value of money so the decision-maker gets a realistic picture of the cost of capital, on the basis of which, informed decisions can be made.