Financing decisions ? dividend decisions and investment decisions

Financial decisions in any business can be essentially divided into two categories; those pertaining to raising of finance and those pertaining to using the finance. The former are known as financing decisions and the latter investment decisions. These are also termed as capital structure and capital budgeting decisions, or source mix and operating decisions, respectively.

When internally generated funds, namely profits are inadequate for the purposes of business, the management necessarily has to raise funds from outside, which may be either in the form of debt or equity. On the other hand, when profits generated in the course of business are sufficiently large, a part of it may be retained for the purposes of the business and the rest distributed away as dividends.

The decision on how much of the profits are to be retained and how much are to be paid out as dividends depends on several factors, such as the need for funds in business, the expectations of the shareholders, availability of investment opportunities to the business, alternative investment opportunities for the shareholders and so on. Ideally, a management should not retain the profits if it cannot reinvest the profits at a rate higher than what the shareholders can earn elsewhere.

 If under such a situation a management retains any profit, the market price of the company’s shares would go down, so that the shareholders wealth will reduce. This will be counter to the corporate financial objective. For the same reason, a management should not distribute dividends if it could earn for its shareholders more than what they could earn elsewhere.

In practice, even when funds are required in the business for various purposes, the management may be constrained to pay out at least some dividends, to meet the shareholders’ expectations. There is a whole lot of theory which describes the impact of dividend payments on the wealth of the shareholders.

Besides financing, the other major preoccupation of the management is to invest the money raised. Clearly, investment would make sense only if a management could earn from a project (say a manufacturing activity) a return, which is in excess of the return expected by the stakeholders, namely the shareholders and the lenders of money on their investments. In general; however, opportunities for investment in the environment may be infinite.

Of these opportunities, the management must be able to identify those opportunities which will yield a positive net present value. i.e. projects whose present value of future expected cash inflows are in excess of the initial investment. Only such a course of action will increase the wealth of the shareholders.

Again, in case the management had access to unlimited amount of funds from the capital market (at least conceptually if not practically) it would be able to accept all the projects with positive net present value, so long as the projects were not mutually exclusive. This; however, is rarely the case; in reality a management often works under funds constraints. Under such a situation, one cannot accept all the projects yielding positive NPVs. Clearly some kind of categorization or ranking or projects is called for, so that the best among them within the constraint of funds available for investment could be accepted. Given the NPV rule and the corporate objective, the best project would be the one with the highest NPV. In general, the cash flows represented by a project are discounted by the weighted average cost of capital of the company in order to arrive at the NPV of the project. Uncertainty of future cash flows adds to the complexity of the investment decisions.