FINANCIAL DECISIONS

These are decisions concerning financial matters of a business firm.

There aim is to maximize shareholders wealth
Examples :- kinds of assets to be acquired, pattern of capitalization,
distribution of firms
income etc.
Financial decisions are of three types :-
FINANCIAL
DECISIONS
INVESTMENT
DECISIONS
FINANCING
DECISIONS
DIVIDEND
DECISIONS
Relates to determination of
total amount of assets to be held in the firm
composition of these assets
business risk complexions of the firm
Most important financial decision as funds available are limited and need to be
utilized properly
Further classified into two categories :-
Long term investment decision or capital budgeting
Short term investment decision or working capital management

1. CAPITAL BUDGETING :- It is the process of making investment decisions in
capital expenditure, benefits of which are expected over a long period of time
exceeding one year . Investment decision should be evaluated in the terms of
expected profitability, costs involved and the risks associated. This decision is
important for setting new units, expansion of present units, reallocation of funds etc.

2. SHORT TERM INVESTMENT DECISION :- It relates to allocation of funds among
cash and equivalents, receivables and inventories. Such decision is influenced by
trade off between liquidity and profitability. Proper working capital management
policy ensures higher profitability, proper liquidity and sound structural health of
the organization.
Firm must decide best means of financing for new assets and best overall mix of
financing for the firm

Select such sources which will make optimum capital structure

Important to decide the proportion of various sources in the overall capital mix

Debt-equity ratio should be fixed in such a way that it helps in maximizing the
profitability of the concern

More debts will increase the return on equity but will involve fixed interest
liability

More equity will bring permanent funds but the shareholders will expect higher
rates of earnings

Therefore there must be a proper balance between various sources

If capital structure is able to minimize the risk and raise the profitability then the
market prices of the shares will go up maximizing the wealth of shareholders.
Dividend Decisions
Relates to the disbursement of profits back to investors who supplied capital to
the firm.
The term dividend refers to that part of profits of a company which is
distributed by it among its shareholders.
It is the reward of shareholders for investments made by them in the share
capital of the company.
A decision has to be taken whether all the profits are to be distributed, to retain
all the profits in business or to keep a part of profits in the business and
distribute others among shareholders.
The higher rate of dividend may rise the market price of the shares and thus,
maximise the wealth of shareholders.
The firm should also consider the question of dividend stability, shock
dividend (bonus shares) and cash dividend.
All financial decisions have same objective i.e. maximization of
shareholders wealth.
All financial decisions influence one another and are Inter-
dependent.
For example, the decision to invest in some proposal cannot be
taken in isolation without having necessary finance available for the
same.
The financing decision in turn is influenced by and also influences
the dividend decision.
In case the profits are retained for financing of the investment, the
profits available for distribution to the shareholders as dividends are
reduced.
An efficient financial management thus, has to be taken the
optimal joint decision by evaluating each of the decision involved in
relation to its effect on shareholders wealth and by considering the
joint impact of these decisions on the market value of the
companys shares.
INVESTMENT
DECISION
DIVIDEND
DECISION
FINANCING
DECISION
Financial Management
Dividend decision
Wealth Maximisation
To achieve
the goal of
Risk and Return
Relationship
(trade off)
Investment decision Financing decision
Is concerned with
Analysis
FINANCIAL MANAGEMENT PROCESS
It begins with the financial planning and decisions.
While implementing these decisions, firm has to acquire certain risk and return
characteristics.
These characteristics determine the market price of shares and shareholders wealth.
The process must include feedback system to enable to take corrective measures, if required.
Following figure depicts the process of financial management
Feedback
Risk and return
Characteristics of the
firm
Market price of
share P
0
Shareholder
Wealth
W
0
= NP
0
FINANCIAL MANAGEMENT PROCESS
Financial planning
and control
Financial decisions
1. Investment decisions
2. Financing decisions
3. Dividend decisions
There are number of (both external as well as internal ) factors that influence the
financial decisions .
A list of the important external as well as internal factors influencing the decisions as
given below:
A. External factors:
State of economy
Structure of capital and money markets
Government policy
Taxation policy
Lending policy of financial institutions
B. Internal factors:
nature and size of business
Expected return, cost and risk
Composition of assets
Structure of ownership
Trend of earnings
Liquidity position
Working capital requirements
Conditions of debt agreements.


Profit earning is the main aim of every economic activity.

It is the measure of efficiency of a business enterprise.

It also serve as a protection against risks

Accumulated profits enable a business to face risks like fall in prices,competition from
other units adverse government policies.

Arguments in favour of profit maximization as the objective of business :-

a) When profit - earning is the aim of business then profit maximization should be the
obvious objective.
b) Profitability is a barometer for efficiency and economic prosperity of a business
enterprise , thus , profit maximization is justified o the grounds of rationality.
c) Business should aim at maximization of profits for enabling its growth and development.
d) A firm by pursuing the objective of profit maximization socio-economic welfare.
e) A business will be able to survive under unfavourable situation, only if it has some past
earnings to rely upon. Therefore a business to try to earn more and more when situation
is favorable.


Profit maximization as an objective of financial management has been considered
inadequate. Even as an operational criterion for maximizing owners economic welfare,
profit maximization has been rejected because of the following drawbacks :-
a) The term profit is vague and it cannot be precisely defined. It means different things
for different people. Even if, we take the meaning of profits as earnings per share and
maximize the earnings per share, it does not necessarily mean increase in the market
value of the shares and the owners economic welfare.
b) It ignores the time value of money and does not consider the magnitude and timings
of earnings. It treats all earnings as equal though they occur in different periods.
c) It does not take into consideration the risk of the prospective earnings stream.
d) The effect of dividend policy on the market price of the shares is also not considered in
this objective.
The following elements are involved in profit maximization.
Increase in revenues all efforts should be made to increase the sales which will
increase the revenue receipts. Profits can be increased either by raising the price of
products or by increasing the volume of sales.
Controlling costs another way of increasing profit is to control or reduce costs.
This will increase the margin of profit per unit. The costs may be controlled by
controlling material wastages,increasing labour efficiency etc.
WEALTH MAXIMIZATION
When the firm maximises the stockholders wealth, the individual stockholder can use this
wealth to maximize his individual utility. It means that by maximizing the stockholders
wealth the firm is operating consistently towards maximizing stockholders utility.

STOCKHOLDERS CURRENT NUMBER OF SHARES * CURRENT STOCK PRICE
WEALTH IN A FIRM = OWNED PER SHARE


MAXIMUM UTILITY MAXIMUM STOCKHOLDERS WEALTH MAXIMUM CURRENT STOCK PRICE PER SHARE
Implications of wealth maximization it serves the interest of suppliers of loaned
capital,employes ,management and society. It not only serves shareholders interests but
insures security to lenders also. Productivity and efficiency of employees is the primary
consideration in raising companys wealth. The efficient allocation of productive resources
will be essential for raising the wealth of the company. The economic interest of the
society are served if various resources are put to economical and efficient use.
CRITICISM OF WEALTH
MAXIMIZATION
It is a prescriptive idea
It is not necessarily socially desirable
There is controversy whether the objective is to maximize stockholders
wealth or wealth of the firm
It may face difficulties when ownership and management are seperated.