Types of Financial Decisions in

Financial Management
Types of Financial Decisions: Investment
Decision, Financing Decision, Dividend Decision
and Working Capital Management Decision
Types of Financial Decisions – That Every Company is Required
to Take: Investment Decision, Financing Decision and Dividend
Decision
Every company is required to take three main financial
decisions, they are:
1. Investment Decision
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2. Financing Decision
3. Dividend Decision
1. Investment Decision:
A financial decision which is concerned with how the firm’s funds are
invested in different assets is known as investment decision.
Investment decision can be long-term or short-term.
A long term investment decision is called capital budgeting decisions
which involve huge amounts of long term investments and are
irreversible except at a huge cost. Short-term investment decisions are
called working capital decisions, which affect day to day working of a
business. It includes the decisions about the levels of cash, inventory
and receivables.
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A bad capital budgeting decision normally has the capacity to severely

damage the financial fortune of a business.
A bad working capital decision affects the liquidity and profitability of
a business.
Factors Affecting Investment Decisions / Capital Budgeting
Decisions:
1. Cash flows of the project- The series of cash receipts and payments
over the life of an investment proposal should be considered and
analyzed for selecting the best proposal.
2. Rate of return- The expected returns from each proposal and risk
involved in them should be taken into account to select the best
proposal.
3. Investment criteria involved- The various investment proposals are
evaluated on the basis of capital budgeting techniques. Which involve
calculation regarding investment amount, interest rate, cash flows,
rate of return etc. It is to be considered which technique to use for
evaluation of projects.
2. Financing Decision:
A financial decision which is 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. Is called financing
decision. In other words, it is a decision on the ‘capital structure’ of the
company.
Capital Structure Owner’s Fund + Borrowed Fund
Financial Risk:
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The risk of default on payment of periodical interest and repayment of

capital on ‘borrowed funds’ is called financial risk.
Factors Affecting Financing Decision:
1. Cost- The cost of raising funds from different sources is different.
The cost of equity is more than the cost of debts. The cheapest source
should be selected prudently.
2. Risk- The risk associated with different sources is different. 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.
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3. Flotation cost- 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.
4. Cash flow position of the business- In case the cash flow position of
a company is good enough then it can easily use borrowed funds.
5. Control considerations- In case the existing shareholders want to
retain the complete control of business then finance can be raised
through borrowed funds but when they are ready for dilution of
control over business, equity shares can be used for raising finance.
6. State of capital markets- During boom period, finance can easily be
raised by issuing shares but during depression period, raising finance
by means of debt is easy.
3. Dividend Decision:
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A financial decision which is concerned with deciding how much of the

profit earned by the company should be distributed among
shareholders (dividend) and how much should be retained for the
future contingencies (retained earnings) is called dividend decision.
Dividend refers to that part of the profit which is distributed to
shareholders. The decision regarding dividend should be taken
keeping in view the overall objective of maximizing shareholder s
wealth.
Factors affecting Dividend Decision:
1. Earnings- Company having high and stable earning could declare
high rate of dividends as dividends are paid out of current and past
earnings.
2. Stability of dividends- Companies generally follow the policy of
stable dividend. The dividend per share is not altered in case earning
changes by small proportion or increase in earnings is temporary in
nature.
3. Growth prospects- In case there are growth prospects for the
company in the near future then, it will retain its earnings and thus, no
or less dividend will be declared.
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4. Cash flow positions- Dividends involve an outflow of cash and thus,
availability of adequate cash is foremost requirement for declaration
of dividends.
5. Preference of shareholders- While deciding about dividend the
preference of shareholders is also taken into account. In case
shareholders desire for dividend then company may go for declaring
the same. In such case the amount of dividend depends upon the
degree of expectations of shareholders.
6. Taxation policy- A company is required to pay tax on dividend
declared by it. If tax on dividend is higher, company will prefer to pay
less by way of dividends whereas if tax rates are lower, then more
dividends can be declared by the company.

Types of Financial Decisions – 3 Types: Investment Decision,

Financing Decision and Dividend Decision
Financial management is concerned with the acquisition, financing
and management of assets with some over all goals in mind. The
contents of modern approach of financial management can be broken
down into three major decisions, viz., (1) Investment decision (2)
Financing decision and (3) Dividend decision.
A firm takes these decisions simultaneously and continuously in the
normal course of business. Firm may not take these decisions in a
sequence, but decisions have to be taken with the objective of
maximising shareholders’ wealth.
Type # 1. Investment Decision:
It is more important than the other two decisions. It begins with a
determination of the total amount of assets needed to be held by the
firm. In other words, investment decision relates to the selection of
assets, on which a firm will invest funds.
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The required assets fall into two groups:

(i) Long-term Assets (fixed assets – plant & machinery land &
buildings, etc.,) which involve huge investment and yield a return over
a period of time in future. Investment in long-term assets is popularly
known as “capital budgeting”. It may be defined as the firm’s decision
to invest its current funds most efficiently in fixed assets with an
expected flow of benefits over a series of years.
(ii) Short-term Assets (current assets – raw materials, work-in-
process, finished goods, debtors, cash, etc.,) that can be converted into
cash within a financial year without diminution in value. Investment
in current assets is popularly termed as “working capital
management”. It relates to the management of current assets.
It is an important decision of a firm, as short-survival is the
prerequisite for long-term success. Firm should not maintain more or
less assets. More assets reduces return and there will be no risk, but
having less assets is more risky and more profitable. Hence, the main
aspects of working capital management are the trade-off between risk
and return.
Management of working capital involves two aspects. One
determination of the amount required for running of business and
second financing these assets.
Type # 2. Financing Decision:
After estimation of the amount required and the selection of assets
required to be purchased, the next financing decision comes into the
picture. Financial manager is concerned with makeup of the right
hand side of the balance sheet. It is related to the financing mix or
capital structure or leverage. Financial manager has to determine the
proportion of debt and equity in capital structure.
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It should be on optimum finance mix, which maximises shareholders’

wealth. A proper balance will have to be struck between risk and
return. Debt involves fixed cost (interest), which may help in
increasing the return on equity but also increases risk. Raising of
funds by issue of equity shares is one permanent source, but the
shareholders will expect higher rates of earnings.
The two aspects of capital structure are- One capital structure theories
and two determination of optimum capital structure.
Type # 3. Dividend Decision:
This is the third financial decision, which relates to dividend policy.
Dividend is a part of profits, which are available for distribution to
equity shareholders. Payment of dividends should be analysed in
relation to the financial decision of a firm. There are two options
available in dealing with net profits of a firm, viz., distribution of
profits as dividends to the ordinary shareholders where there is no
need of retention of earnings or they can be retained in the firm itself
if they are required for financing of any business activity.
But distribution of dividends or retaining should be determined in
terms of its impact on the shareholders’ wealth. Financial manager
should determine the optimum dividend policy, which maximises
market value of the share thereby market value of the firm.
Considering the factors to be considered while determining dividends
is another aspect of dividend policy.

Types of Financial Decisions – Capital Budgeting Decisions,

Capital Structure Decisions and Dividend Decision
There are four main financial decisions- Capital Budgeting or Long
term Investment decision (Application of funds), Capital Structure or
Financing decision (Procurement of funds), Dividend decision
(Distribution of funds) and Working Capital Management Decision in
order to accomplish goal of the firm viz., to maximize shareholder’s
(owner’s) wealth.
Sometimes all the above four decisions are classified into
three decisions as follows:
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i. Investment decision – which involves capital budgeting decision

(long term investment decision) and working capital management.
ii. Capital structure
iii. Dividend decision
i. Capital Budgeting Decision:
The process of planning and managing a firm’s long-term investments
is called capital budgeting. In capital budgeting, the financial manager
tries to identify profitable investment opportunities, i.e., assets for
which value of the cash flow generated by asset exceeds the cost of that
asset. Evaluating the size, timing, and risk of future cash flows (both
cash inflows & outflows) is the essence of capital budgeting.
A finance manager has to find answers to questions such as:
i. What should be the size of firm?
ii. In which assets / projects funds should be invested?
iii. Investments in which assets / projects should be reduced or
discontinued?
Capital budgeting decisions determine the fixed assets composition of
a firm’s Balance Sheet. Capital budgeting decision gives rise to
operating risk or business risk of a firm.
Risk-Return Trade-Off:
Risk and return move in tandem. Higher the risk, higher the return.
Lower the risk, lower the return. This holds true for all investments
(projects & assets).
A finance manager seeks to select projects / assets which:
(a) Minimize the risk for given level of return or
(b) Maximize return for given degree of risk.
Hence there is a risk return trade off in case of capital budgeting
decision. Investment in small plant is less risky than investment in
large plant. But at the same time small plant generates lower return
than a large plant. Hence deciding about the optimal size of the plant
requires a careful analysis of risk and return.
ii. Capital Structure Decision:
A firm’s capital structure or financing decision is concerned with
obtaining funds to meet firm’s long term investment requirements. It
refers to the specific mixture of long-term debt and equity, which the
firm uses to finance its assets. The finance manager has to decide
exactly how much funds to raise, from which sources to raise and
when to raise.
Different feasible combinations of raising required funds must be
carefully evaluated and an optimal combination of different sources of
funds should be selected. The optimal capital structure is one which
minimises overall cost of capital and maximises firm’s vale. Capital
structure decision gives rise to financial risk of a firm.
Risk-Return Trade-Off:
Risk return tradeoff is involved in capital structure decision as well.
Usually Debt is considered cheaper than equity capital because
interest on debt is tax deductible. Also since debt is paid before equity,
risk is lower for investors and so they demand lower return on debt
investments. But excessive debt is riskier than equity capital from the
company’s viewpoint as debt obligations have to be compulsorily met
even if firm incurs losses.
Thus there is a risk-return trade-off in deciding the optimal financing
mix. On one hand, debt has lower cost of capital thus employing more
debt would mean higher returns but is riskier while on the other hand,
equity capital gives lower return due to higher cost of capital but is less
risky.
iii. Dividend Decision:
Dividend decision involves two issues-whether to distribute dividends
and how much of profits to distribute as dividends. A finance manager
has to decide what percentage of after tax profit is to be retained in the
business to meet future investment requirements and what proportion
has to be distributed as dividend among shareholders. Should the firm
retain all profits or distribute all profits or retain a portion and
distribute the balance?
Proportion of profits distributed as dividend is called dividend pay-out
ratio and the proportion of profits retained in the business is retention
ratio. Finance manager here is concerned with determining the
optimal dividend pay-out ratio which maximises shareholder’s wealth.
However, the actual decision is affected by availability of profitable
investment opportunities, firm’s financial needs, shareholder’s
expectations, legal constraints, liquidity position of the firm and other
factors.
Risk Return Trade Off:
Dividend decision also involves risk return trade off. Generally
investors expect dividends because dividends resolve future un-
certainty attached with capital gains. So a company should pay
dividends. However when a company, having profitable investment
opportunities pays dividends, it has to raise funds from external
sources which are costlier than retained earnings.
Hence return from the project reduces. A high dividend payout is less
risky but also results in less return while a low dividend payout is
more risky but results in high return in case of growing firms.
Therefore a firm has to strike a balance between dividends and
retained earnings so as to satisfy investors’ expectations.
iv. Working Capital Management Decision:
Working capital management is concerned with management of a
firm’s short-term or current assets, such as inventory, cash,
receivables and short-term or current liabilities, such as creditors, bills
payable. Assets and Liabilities which mature within the operating
cycle of business or within one year are termed as current assets and
current liabilities respectively.
Working capital management involves following issues:
(1) What are the possible sources of raising short term funds?
(2) In what proportion should the funds be raised from different short
term sources?
(3) What should be the optimum levels of cash and inventory?
(4) What should be the firm’s credit policy while selling to customers?
Risk-Return Trade-Off:
Working capital management also involves risk-re- turn trade off as it
affects liquidity and profitability of a firm. Liquidity is inversely
related to profitability, i.e., increase in liquidity results in decrease in
profitability and vice versa. Higher liquidity would mean having more
of current assets. This reduces risk of default in meeting short term
obligations.
But current assets provide lower return than fixed assets and hence
reduce profitability as funds that could earn higher return via
investment in fixed assets are blocked in current assets. Thus higher
liquidity would mean lower risk but also lower profits and lower
liquidity would mean more risk but more returns. Therefore the
finance manager should have optimal level of working capital.
Inter-Relationships between Financial Decisions:
All the four financial management decisions explained above are not
independent but related with each other’s. Capital budgeting decision
requires calculation of present values of cost and benefits for which we
need some appropriate discount rate. Cost of capital which is the
result of capital structure decision of a firm is generally used as the
discount rate in capital budgeting decision.
Hence investment and financing decisions are interrelated. When
operating risk of a business is high due to huge investment in long
term assets (i.e. capital budgeting decision) then companies should
have low debt capital and less financial risk. Dividend decision
depends upon the operating profitability of a firm which in turn
depends on the capital budgeting decision.
Sometimes firms use retained earnings for financing their investment
projects and if some amount of profit is left, that amount is distributed
as dividend. Hence there is a relationship between dividends and
capital budgeting on one hand and dividends and financing decision
on the other.

Types of Financial Decisions – Long-Term and Short-Term

Decisions
The functions of raising funds, investing in assets and distributing
returns to shareholders are main financial functions or financial
decisions in a firm.
The finance functions are divided into long-term and short-
term decisions as mentioned below:
(a) Long-Term Finance Decisions:
(i) Investment decision
(ii) Financing decision
(iii) Dividend decision
(i) Investment Decision:
To take a long-term investment decision, various capital budgeting
techniques are used. Risk return trade-off is involved in capital
budgeting decision. For a given degree of risk, project giving the
maximum net present value is selected.
The objective of financial management is to maximise shareholders’
wealth. Hence, investment decision is most crucial in attaining the
objective. After a careful analysis of risk return trade-off, the size of
plant should be determined.
(ii) Financing Decision:
Financing decision is concerned with the capital structure of the firm.
The decision is basically taken about proportion of equity capital and
debt capital in total capital of the firm. Higher the proportion of debt
in capital of the firm, higher is the risk. A capital structure having a
reasonable mix of equity capital and debt capital is called optimum
capital structure.
Financing should be from sources having lowest cost of capital. A
number of factors affect the capital structure of a firm. Debt has lower
cost of capital, but it increases risk in the business of the firm. A
leveraged firm carries higher degree of risk in business. A reasonable
mix of debt and equity capital should be selected to maintain the
balance between risk and return.
(iii) Dividend Decision:
The third major decision is concerned with the distribution of profit to
shareholders. A finance manager has to decide how much proportion
of profit should be distributed to shareholders.
If a firm needs funds for investment in available projects and the cost
of external financing is higher, then it is better to retain profit to meet
the requirement. The payment of dividends also affect the value of
firms. These factors should be taken into consideration while deciding
the optimal dividend policy of the firm.
(b) Short-Term Finance Decisions:
Liquidity Decision:
A firm needs working capital to manage the day-to-day affairs
smoothly. Working capital means firm’s total investment in current
assets. Net working capital is equal to difference between the total
current assets and current liabilities.
In working capital management, a finance manager has to
take decision on following issues:
(i) What should be the total investment in working capital of the firm?
(ii) What should be the level of individual current assets?
(iii) What should be the relative proportion of different sources to
finance the working capital requirement?
(iv) What should be the firm’s credit policy while selling to customers?
Management of working capital involves risk-return trade-off. If the
level of current assets of the firm is very high, it has excess liquidity.
When the firm does so its rate of return will decline as more funds are
tied up in idle cash. If the firm’s level of current assets is low, it would
result in interrupted production and sales. This would lead to
reduction in profit. Thus a firm should maintain optimum level of
current assets.

Types of Financial Decisions – 4 Types: Financing Decision,

Investment Decision, Dividend Decision and Working Capital
Decisions
The key aspects of financial decision-making relate to financing,
investment, dividends and working capital management. Decision
making helps to utilise the available resources for achieving the
objectives of the organization, unless minimum financial performance
levels are achieved, it is impossible for a business enterprise to survive
over time. Therefore financial management basically provides a
conceptual and analytical framework for financial decision making.
1. Financing Decision:
All organizations irrespective of type of business must raise funds to
buy the assets necessary to support operations.
Thus financing decisions involves addressing two questions:
I. How much capital should be raised to fund the firm’s operations
(both existing & proposed?)
II. What is the best mix of financing these investment proposals?
The choice between the use of internal versus external funds, the use
of debt versus equity capital and the use of long-term versus short-
term debt depends on type of source, period of financing, cost of
financing and the returns thereby. Prior to deciding a specific source
of finance it is advisable to evaluate advantages and disadvantages of
different sources of finance and its suitability for purpose.
Efforts are made to obtain an optimal financing mix, an optimal
financing indicates the best debt-to-equity ratio for a firm that
maximizes its value, in simple words, and the optimal capital structure
for a company is the one which offers a balance between cost and risk.
2. Investment Decision:
This decision in financial management is concerned with allocation of
funds raised from various sources into acquisition assets or
investment in a project.
The scope of investment decision includes allocation of
funds towards following areas:
i. Expansion of business
ii. Diversification of business
iii. Productivity improvement
iv. Product improvement
v. Research and Development
vi. Acquisition of assets (tangible and intangible), and
vii. Mergers and acquisitions.
Further, Investment decision not only involves allocating capital to
long term assets but also involves decisions of utilizing surplus funds
in the business, any idle cash earns no further interest and therefore
not productive. So, it has to be invested in various as marketable
securities such as bonds, deposits that can earn income.
Most of the investment decisions are uncertain and a complex process
as it involves decisions relating to the investment of current funds for
the benefit to be achieved in future. Therefore while considering
investment proposal it is important to take into consideration both
expected return and the risk involved. Thus, finance department of an
organization has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.
3. Dividend Decision:
Shareholders are the owners and require returns, and how much
money to be paid to them is a crucial decision. Thus payment of
dividend is decision involves deciding whether profits earned by the
business should be retained rather than distributed to shareholders in
the form of dividends.
If dividends are too high, the business may be starved of funding to
reinvest in growing revenues and profits further. Keeping this in mind
an optimum dividend payout ratio is calculated by the finance
manager that would help the firm to maximize its market value.
4. Working Capital Decisions:
In simple words working capital signifies amount of funds used in its
day-to-day trading operations. Working capital primarily deals with
currents assets and current liabilities. Infact it is calculated as the
current assets minus the current liabilities. One of the key objectives of
working capital management is to ensure liquidity position of a firm to
avoid insolvency.
The following are key areas of working capital decisions:
i. How much inventory to keep?
ii. Deciding ratio of cash and credit sales
iii. Proper management of cash
iv. Effective administration of bills receivables and payables
v. Investment of surplus cash.
The principle of effective working capital management focuses on
balancing liquidity and profitability. The term liquidity implies the
ability of the firm to meet bills and the firm’s cash reserves to meet
emergencies. Whereas the profitability means the ability of the firm to
obtain highest returns within the funds available. In order to maintain
a balance between profitability and liquidity forecasting of cash flows
and managing cash flows is very important.

Types of Financial Decisions – With Factors Affecting It

Financial Management takes financial decisions under three main
categories namely, investment decisions, financing decisions and
dividend decisions.
Let us now discuss each financial decision in detail:
Type # 1. Investment Decision:
Investment decisions are the financial decisions taken by management
to invest funds in different assets with an aim to earn the highest
possible returns for the investors. It involves evaluating various
possible investment opportunities and selecting the best options. The
investment decisions can be long term or short term.
Long Term Investment Decisions:
Long term investment decisions are all such decisions which are
related to investing of funds for a long period of time. They are also
called as Capital Budgeting decisions.
The long term investment decisions are related to management of
fixed capital. These decisions involve huge amounts of investments
and it is very difficult to reverse such decisions. Therefore, it is must
that such decisions are taken only by those people who have
comprehensive knowledge about the company and its requirements.
Any bad decision may severely damage the financial fortune of the
business enterprise.
Factors Affecting Capital Budgeting (Long Term Investment)
Decisions:
While taking a capital budgeting decision, a business has to evaluate
the various options available and check the viability and feasibility of
the available options.
The various factors which affect capital budgeting decisions
are:
(i) Cash Flow of the Project- Before considering an investment option,
business must carefully analyse the net cash flows expected from the
investment during the life of the investment. Investment should be
done only if the net cash flows are more than the funds invested.
(ii) The Rate of Return- The rate of return is the most important factor
while taking an investment decision. The investment must be done in
the projects which earn the higher rate of return provided the level of
risk is same.
(iii) The Investment Criteria Involved- Before taking decision, each
investment opportunity must be compared by using the various capital
budgeting techniques. These techniques involve calculation of rate of
return, cash flows during the life of investment, cost of capital etc.
Importance of long term investment decisions:
(i) They directly affect the profitability or earning capacity of the
business enterprise.
(ii) They affect the size of assets, scale of operations and
competitiveness of business enterprise.
(iii) They involve huge amounts of investment which remains blocked
in the fixed assets for a long period of time.
(iv) The investments are irreversible except at a huge cost.
Examples of capital budgeting decisions:
(i) Investment in plant and machinery
(ii) Purchase or takeover of an existing business firm
(iii) Starting a new factory or sales office
(iv) Introducing new product line
Short Term Investment Decisions:
Short term investment decisions are the decisions related to day to day
working of a business enterprise. They are also called as working
capital decisions because they are related to current assets and current
liabilities like management of cash, inventories, receivable etc.
The short term decisions are important for a business
enterprise because:
(i) They affect the liquidity and profits earned in the short run.
(ii) Efficient decisions help to maintain sound working capital.
Type # 2. Financing Decision:
Financing decisions are the financial decisions related to raising of
finance. It involves identification of various sources of finance and the
quantum of finance to be raised from long-term and short-term
sources.
A firm can raise long term finance either through shareholders’ funds
or borrowed capital.
The financial management as part of financing decision, calculates the
cost of capital and the financial risks for various options and then
decides the proportion in which the funds will be raised from
shareholders’ funds and borrowed funds.
While taking financing decision following points need to be
considered:
(i) While borrowed funds carry interest to be paid irrespective of
whether or not a firm earns profit but the shareholders’ funds do not
carry any commitment of returns to be paid. Shareholders receive
dividends when business earns profits.
(ii) Borrowed funds have to be repaid at the end of a fixed period of
time and there is financial risk in case of default in payment but
shareholders’ funds are repayable only at the time of liquidation of
business.
(iii) The fixed cost paid on borrowed funds is a business expense, it
saves tax leading to reduced cost of capital whereas the dividends paid
on shareholders’ funds is appropriation of profits thus does not reduce
tax liability of business.
(iv) The fund raising exercise involves floatation cost which must be
considered while evaluating different sources.
In order to raise capital with controlled risk and minimum cost of
capital a firm must have a judicious mix of both debt and equity.
Therefore, cost of each type of finance is calculated before taking the
financial decision of how much funds to be raised from which source.
This decision determines the overall cost of capital and the financial
risk for the enterprise.
Factors Affecting Financing Decision:
From the above discussions, you must have realized that financing
decisions are affected by various factors.
Some of the important factors are:
(i) Cost:
Cost of raising funds influence the financing decisions. A prudent
financial manager selects the cheapest sources of finance.
(ii) Risk:
Each source of finance has different degree of risk. Finance manager
considers the degree of risk involved in each source of finance before
taking financing decision. For example, borrowed funds have high risk
as compared to equity capital.
(iii) Floatation Costs:
Floatation cost is the cost of raising finance. A finance manager
estimates the floatation cost of various sources and selects the source
with least floatation cost. Therefore, higher the floatation cost less
attractive is the source of finance.
(iv) Cash Flow Position of the Business:
A business with strong cash flow position prefers to raise funds from
debts as it can easily pay interest and the principal. Interest is a
deductible expense, saves tax liability of the business making the
source of finance cheaper. However, during liquidity crisis business
prefers to raise funds from equity.
(v) Level of Fixed Operating Costs:
Fixed operating costs of a business influence its financing decisions.
For a business with high operating cost, funds must be raised from
equity as lower debt financing would be better. On the other hand, if
the operating cost is low, business can afford to pay high fixed charges
therefore, more of debt financing may be preferred.
(vi) Control Considerations:
Financing decisions consider the degree of control the business is
willing to dilute. A company would prefer debt financing if it wants to
retain complete control of the business with existing shareholders. On
the other hand, a company willing to lose control will raise funds from
equity.
(vii) State of Capital Markets:
Health of the capital market may also affect the financing decision.
During boom period, investors are ready to invest in equity but during
depression investors look for secured options for investment.
Therefore it is easy for companies to raise funds from equity during
boom period.
Type # 3. Dividend Decision:
Dividend decisions are the financial decisions related to distribution of
share of profits amongst shareholders in the form of dividends. The
dividend decision involves deciding the amount of profit (after tax) to
be distributed to the shareholders as dividends and the amount of
profit to be retained in the business for further growth of the business.
Dividend decisions should be taken keeping in view the overall
objective of maximizing shareholders’ wealth.
Factors Affecting Dividend Decisions:
The decision regarding the amount of profits to be distributed as
dividends depends on various factors.
Some of the factors may be stated as follows:
(i) Earnings:
Dividends represent the share of profits distributed amongst
shareholders. Therefore, earnings is a major determinant of the
decision regarding dividends.
(ii) Stability of Earnings:
A company with stable earnings is not only in a position to declare
higher dividends but also maintain the rate of dividend in the long
run. However a company with fluctuating earnings may declare
smaller dividend.
(iii) Stability of Dividends:
In order to maintain dividend per share, a company prefers to declare
same rate of dividends. However the decision to change the rate of
dividend can be taken only if there is increase in the company’s
potential to earn profits not only in the current year but also in the
future.
(iv) Growth Opportunities:
The growing companies prefer to retain larger share of profits to
finance their investment requirements. Therefore, the rate of dividend
declared by them is smaller as compared to companies who have
achieved certain goals of growth and can share larger share of profits
with shareholders.
(v) Cash Flow Positions:
Dividends involve outflow of cash. A profitable company is in a
position to declare dividends but it may have liquidity problems. As a
result of which it may not be in a position to pay dividends to its
shareholders. Therefore availability of cash also influences dividend
decision.
(vi) Shareholders’ Preference:
Management of a company takes into consideration its shareholders
expectations for dividends and try to take dividend decisions
accordingly. For example, a company may declare higher or stable rate
of dividend if it has a large number of shareholders who depend on
dividends as their regular income.
(vii) Taxation Policy:
Dividends are a tax free income for shareholders but the company has
to pay tax on share of profits distributed as dividend. Therefore, the
decision regarding the amount of profit to be distributed as dividends
depends on the tax rate. Company would prefer to pay lesser dividends
if tax rate on dividends is high.
(viii) Stock Market Reactions:
The share price is directly related to the rate of dividend declared by
the company. Share prices of a company increase if the company
declares higher rate of dividend. Therefore, the financial management
considers the potential effect of dividends on the share prices before
declaring dividends.
(ix) Access to Capital Markets:
Decision regarding amount of dividend to be declared depends on the
need of profits to be retained for future investments. Companies who
have easy access to the capital market to raise funds may not require
large amount of profits to be retained and therefore may decide to
declare high dividend rate. On the other hand, small companies who
find it difficult to raise funds from capital markets may decide to share
lesser profits with their shareholders.
(x) Legal Constraints:
Every company is required to adhere to the restrictions or provisions
laid by the Companies Act regarding dividend payouts.
(xi) Contractual Constraints:
Sometimes companies are required to enter into contractual
agreements with their lenders with respect to the payment of
dividends in future. The dividend decisions need to consider such
restrictions while declaring dividend rate to ensure that terms of loan
agreement are not violated.