Financial decisions: Investment Decisions, Financing Decisions and Dividend Decisions - Lessonnotes (2024)

Financial decisions are the decisions that managers make to maximize the value of their firms.

They can be classified into three main categories: investment decisions, financing decisions, and dividend decisions.

Financing decisions involve the critical task of determining how to source the necessary funds to support a company’s operations and future endeavors; investment decisions revolve around the allocation of available resources to different investment opportunities and projects, while dividend decisions are concerned with deciding how much profit will be distributed to the shareholders of a company.

Now, let’s look at each of these financial decisions in detail.

Investment decision

Investment decisions are the decisions about how to allocate the firm’s resources to different projects or assets

It involves deciding on what asset to invest in to maximize the return on the investment.

That is, investment decisions involve deciding on what to buy with the company’s limited resources in order to earn the highest possible return.

Investment decisions can be categorized into short term and long term.

1. Short term investment decisions: These are concerned with the liquidity and profitability of a business. They are decisions that ensure that a company has enough resources to meet its day-to-day expenses. Short term investment decisions involve deciding on the working capital management of a firm. Therefore, it is also called working capital decision.
2. Long term investment decisions: These are decisions that relate to committing funds to fixed assets over a long period. Examples of long-term investment decisions are buying equipment, machinery. Long term investment decisions are sometimes known as capital budgeting decisions because they involve investment decisions concerning a company’s fixed asset.

Factors Affecting Investment Decisions

1. OperationalCash flow: When a company invests, it expects to generate some cash flow to meet everyday expenses.

This cash flow may be in the form of cash receipt or payment.

Therefore, the amount of cash flow is an important factor that should be considered while making investment decisions.

2. Rate of return: This is the arguably the most important factor in most investment decisions.

The rate of return is the net gain (or loss) of an investment expressed as a percentage of the original cost of the investment.

To illustrate, suppose there are two projects A and B and both have the same number of risks. Suppose that Project A has a 24% rate of return and project B has a 20% rate of return.

Then, under normal circ*mstances Project A will be chosen over the project B.

3. Investment criteria involved: When a business wants to make an investment decision, it must consider different investment criteria.

Generally, businesses usually consider the following investment criteria:

• Will the investment maximize the value of the firm, considering the amount of risk involved in the investment?
• How will the investment be financed appropriately?

Financing decision

Every business function (marketing, human resources, etc) requires one form of payment or another.

Hence, financial managers must also make financing decisions.

Financing decisions are the decisions about how to raise funds to finance the investments and core functions of a business.

It involves identifying and determining the sources of funding that are accessible to a company.

Financing decisions involves deciding on when, where and how to acquire funds to meet the firm’s investment needs.

Simply said, financial decisions involve determining the amount of money that can be raised from both short and long-term sources of capital.

These sources of capital can be in two forms:

• Shareholders’ funds, which consists of equity capital and the retained earnings.
• Debt funds, which are monies received through debt instruments such as debentures. Debt funds are usually repaid with interest.

In making a financial decision, a firm has to decide on the optimal capital structure.

That is, it must decide on what proportion of its funds would come from shareholders and debt funds.

Because it entails deciding on the capital structure or mix of the business, a financing decisions are also called capital mix decision.

Factors Affecting Financing Decision

1. Capital Cost: The cost of raising funds from various sources varies.

Borrowed money, for example, frequently come with interest (the cost of borrowing funds), which is usually paid whether or not a company makes a profit.

However, finance from shareholders is usually cost-effective as there do not attract interest, even though the company must paid dividends to shareholders.

As such, a prudent financial manager should select the most cost-effective means of raising funds.

2. Risk involved: The financial risk associated with various sources of finance differ.

Usually, borrowed funds come with higher financial risk than equity funds.

It is up to the financial manager to identify the different available sources of finance and compare them in terms of the associated risks.

3. Floatation cost: Firms usually incurred floatation costs when they issue securities in the primary market.

To define it, a floatation cost is a cost incurred when new securities are issued.

Usually, the higher the floatation cost, the less attractive the source of finance and vice versa.

So, a financial manager must also consider the floatation cost when making financing decisions.

4. Cash flow position of the company: Cash flow is the movement of cash in and out of the business.

If the organization wants to borrow money from outside sources, it needs to have a more stable cash flow.

5. Business cycle: When the economy is growing, individuals tend to invest in equity, making it easier to access capital from the capital market.

On the other hand, when there is a recession, it becomes more difficult to raise funds from the equity market since people are less willing to invest.

As a result, the business would have to rely on debt financing to stay afloat.

Dividend Decision

Dividend refers to the portion of a company profit distributed to shareholders.

Dividend decisions involve determining how much of a company’s profit should be distributed to shareholders and how much should be reinvested in the company (as retained earnings).

When making dividend decisions, financial managers must decide whether to distribute all profits, retain them, or distribute a portion and retain the balance.

Dividend decision is also called profit allocation decision because it involves deciding on what percentage of profit should be allocated to the shareholders (dividend) and the business (retained earnings).

Factors Affecting Dividend Decisions

1. Profit of the business: Dividends are paid to shareholders depending on the company’s current and previous earnings.

As a result, profit is an important consideration when deciding whether or not to pay a dividend.

2. Stability of earnings: As noted earlier, a company paid dividends from present and past earnings.

So, therefore, a company with stable earnings is in a better position to pay dividends than one with unstable earnings.

3. Cash flow position: Dividend represents an outflow of cash.

As a result, to pay dividends, a corporation must have sufficient cash.

Hence, the availability of cash is another factors that a finance manager would consider making dividend decisions.

4. Growth opportunities: Companies with strong growth prospects usually prefer to retain their earnings to fund the growth prospects.

As a result, dividend payments in such organizations typically remain lower compared to those with limited growth prospects.

Also, If a majority of shareholders request that a portion of the company’s income be distributed as dividends, the company is likely to heed their request.

This ensures that shareholders who depend on dividend income to meet their financial needs are appropriately rewarded and supported.