FINANCIAL DECISIONS
• These are decisions concerning financial matters of a business firm.
• There aim is to maximize shareholder’s wealth
• Examples :- kinds of assets to be acquired, pattern of capitalization,
distribution of firm’s
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
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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.
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All financial decisions have same objective i.e. maximization of
shareholders’ wealth.
All financial decisions influence one another and are Interdependent.
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
company’s shares.
INVESTMENT
DECISION
FINANCING
DECISION
DIVIDEND
DECISION
Financial Management
Is concerned with
Financing decision
Investment decision
Analysis
Risk and Return
Relationship
(trade off)
To achieve
the goal of
Wealth Maximisation
Dividend decision
FINANCIAL MANAGEMENT PROCESS
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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
FINANCIAL MANAGEMENT PROCESS
Financial planning
and control
Feedback
Financial decisions
1. Investment decisions
2. Financing decisions
3. Dividend decisions
Risk and return
Characteristics of the
firm
Market price of
share P0
Shareholder
Wealth
W0 = NP0
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There are number of (both external as well as internal ) factors that influence the
financial decisions .
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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.
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Profit earning is the main aim of every economic activity.
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It is the measure of efficiency of a business enterprise.
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It also serve as a protection against risks
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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 :-
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.
a)
 Profit maximization as an objective of financial management has been considered
inadequate. Even as an operational criterion for maximizing owner’s economic welfare,
profit maximization has been rejected because of the following drawbacks :a)
b)
c)
d)
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 owner’s economic welfare.
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.
It does not take into consideration the risk of the prospective earnings stream.
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 stockholder’s wealth, the individual stockholder can use this
wealth to maximize his individual utility. It means that by maximizing the stockholder’s
wealth the firm is operating consistently towards maximizing stockholder’s utility.
STOCKHOLDER’S CURRENT
WEALTH IN A FIRM
=
MAXIMUM UTILITY
NUMBER OF SHARES
OWNED
MAXIMUM STOCKHOLDER’S WEALTH
*
CURRENT STOCK PRICE
PER SHARE
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 shareholder’s interests but
insures security to lenders also. Productivity and efficiency of employees is the primary
consideration in raising company’s 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 stockholder’s
wealth or wealth of the firm
 It may face difficulties when ownership and management are seperated.
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