Everything you need to know about the types of financial decisions taken by a company. 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.
The types of financial decisions can classified under:- 1. Long-Term Finance Decisions 2. Short-Term Finance Decisions.
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There are four main financial decisions:- 1. Capital Budgeting or Long term Investment Decision 2. Capital Structure or Financing Decision 3. Dividend Decision 4. Working Capital Management Decision.
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
2. Financing Decision
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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.
A bad capital budgeting decision normally has the capacity to severely damage the financial fortune of a business.
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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:
The risk of default on payment of periodical interest and repayment of capital on ‘borrowed funds’ is called financial risk.
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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.
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.
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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:
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.
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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.
4. Cash flow positions- Dividends involve an outflow of cash and thus, availability of adequate cash is foremost requirement for declaration of dividends.
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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.
The required assets fall into two groups:
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(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.
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.
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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:
i. Investment decision – which involves capital budgeting decision (long term investment decision) and working capital management.
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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.
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 uncertainty 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.