Financing is the most serious issue that every enterprise faces. Judicious decision is to be made by the Finance Manager as to the amount of finance to be raised and the sources of raising it.
Meaning and Definition
Financing decision refers to the decision regarding the amount of finance to be raised and identifying the various available sources for raising the finance. It is a part of financial management, which is concerned with taking decision regarding the best means of financing. The main sources of funds for a firm are owner's funds or Equity and borrowed funds or Debt. Owner's fund consists of equity share capital, preference share capital and retained earnings. Borrowed funds refer to the finance raised through debentures, loans, public deposits, etc. Inorder to decide the relative proportion between equity and debt, the cost of each source, risk involved, cost of floatation etc, are to be taken into consideration. A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions
The financial decision is defined as, "the decision concerned with the quantum of funds to be raised and determining the various sources available for financing the requirements"
Factors affecting Financing Decisions While taking financing decisions, the finance manager has to consider the following factors
1. Cost: The cost of raising finance from various sources is different and finance managers would normally opt for a source which is the cheapest.
2. Risk: The degree of risk associated with each source of fund is not the same. T it should be properly assessed before making financing decisions. For example, deb is more risky as compared to equity shares..
3.Floatation Costs: Flotation cost refers to the cost involved in issue of securities such Hence,as underwriting commission, brokerage, expenses of prospectus etc. The floatation cost of various sources is carefully estimated and securities with least flotation cost are preferred by the firms.
4. Cash Flow Position of the Company: The cash flow position of the firm is an important determinant of the repaying capacity as and when the payments became due. A company with stronger cash flow position may find debt financing more viable than funding through equity.
5. Fixed Operating Costs: When fixed operating costs like rent, insurance premium etc. are high, the company may prefer owners fund and reduce fixed interest bearing obligations.
6. Control Considerations: If the management wants to retain existing control, they prefer borrowed funds, as issue of more equity may lead to dilution of control.
7.State of Capital Market: When the stock index is improving, more people will be ready to invest in equity. But during depression period, financing through debt fund will be easier and more preferable to equity share capital.
Sources of Finance
In the present day business, finance is the provision of money at the time when it is required. Adequate finance is inevitable one for every business organisation irrespective of size, nature and scale of operation. Hence, it is rightly said that finance is the life blood of every business organisation. Every business organisation needs finance mainly for two purposes:
i.to facilitate production facilities, and
ii.to carry out day-to-day operations.
Finance needed to support production facilities is termed as long term finance or fixed capital and finance needed for day-to day operations are referred to as short term finance or working capital. The various sources of finance may broadly be divided into long term sources and short term sources.
Long Term Sources
Long term sources refer to raising of finance normally for a period beyond one year. It is composed of raising of funds through shares, debentures, bonds, retained earnings, financial institutions, sale of fixed assets etc. The financing through shares, debentures and bonds is known as security financing.
1. Issue of Shares
Financing through shares is the important source used by companies for raising capital. Equity shares and preference shares are the different types of shares issued by the companies.
A. Financing through Equity Shares
Equity shares are the foundation of the financial structure of the company. They are also known as ordinary shares or common shares representing ownership capital. Equity shares are those shares which have no preferential right for getting dividend and repayment of capital at the time of winding up. According to Sec. 43 of the Companies Act, 2013, "Equity shares are those shares which are not preference shares". They are paid only after paying dividend to preference shareholders. They are the real owners of the company and participate in the control and management of the company through enjoying voting power. The finance procured through equity shares is a permanent source of funds to the company.as it need not be redeemed during the life time of the company.
Characteristics of Equity Shares
Equity shares have a number of characteristics which distinguish them from other shares and securities. The following are the important features of equity shares.
1. Maturity: Equity shares provide permanent capital to the company and cannot be redeemed during the lifetime of the company. Equity shareholders can demand refund
of their capital only at the time of liquidation of the company. At the same time, share holders may get back money from the sale of shares through stock exchange. The shares are sold in the stock exchange at a price which is known market price The market value of a share is purely based on the demand for the shares.
2. Claim on income: Equity shareholders have a residual claim on the income of the company. They have a claim on income left after paying dividend to preference shareholders. In periods of insufficient profits they may not get any thing, but during prosperity they get high return.
3. Claim on assets: Equity shareholders have a residual claim on ownership of company's assets. In the event of liquidation of a company, the assets are utilised first to meet the claims of creditors and preference shareholders and if any thing is left, it belongs to equity shareholders. Equity shares provide a cushion to absorb losses on liquidation.
4. Right to control or voting right: Equity shareholders are the real owners of the company. They have voting right in the meeting of the company and have a control over its working. The control of the company is vested with the Board of Directors who are elected by the equity shareholders.
5. Pre-emptive right: When a company makes subsequent issue of capital, it must be first offered to the existing shareholders. This right of the existing shareholders is called pre-emptive right. The shares thus issued are called right shares.
6. Limited liability: Limited liability means that the liability of a shareholder is limited to the extent of the face value of shares held by him.
Advantages of Equity Shares
1. Equity share capital is a permanent source of fund.
2. Equity shares do not create obligation to pay a fixed rate of dividend.
3. Fresh issue of equity shares provides flexibility to the capital structure as funds are obtained without creating any charge over the assets of the company.
4. By issuing right shares, it is possible to raise additional funds without diluting the control of existing shareholders.
5. Equity shareholders have voting rights
Disadvantages of Equity Shares
1. Cost of equity capital is the highest of all sources.
2.Payment of dividend will attract Corporate Dividend Tax which is an additional burden to the company.
3. 4. Additional issue of equity shares will reduce earning per share. If only equity shares are issued, the company cannot take the advantage of trading on equity.
5. There is no assurance on dividend on equity shares.