Definition: The Financing Decision is yet another crucial decision made by the financial manager relating to the financing-mix of an organization. It is concerned with the borrowing and allocation of funds required for the investment decisions.
The financing decision involves two sources from where the funds can be raised: using a company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form debenture, loan, bond, etc. The objective of financial decision is to maintain an optimum capital structure, i.e. a proper mix of debt and equity, to ensure the trade-off between the risk and return to the shareholders.
The Debt-Equity Ratio helps in determining the effectiveness of the financing decision made by the company. While taking the financial decisions, the finance manager has to take the following points into consideration:
- The Risk involved in raising the funds. The risk is higher in the case of debt as compared to the equity.
- The Cost involved in raising the funds. The manager chose the source with minimum cost.
- The Level of Control, the shareholders, want in the organization also determines the composition of capital structure. They usually prefer the borrowed funds since it does not dilute the ownership.
- The Cash Flow from the operations of the business also determines the source from where the funds shall be raised. High cash flow enables to borrow debt as interest can be easily paid.
- The Floatation Cost such as broker’s commission, underwriters fee, involved in raising the securities also determines the source of fund. Thus, securities with minimum cost must be chosen.
Thus, a company should make a judicious decision regarding from where, when, how the funds shall be raised, since, more use of equity will result in the dilution of ownership and whereas, higher debt results in higher risk, as fixed cost in the form of interest is to be paid on the borrowed funds.