What is Investment & Financing Decision ?

1. Investment Decision 

It refers to the selection of those assets in which the funds will be invested by the business or by any individual. Assets which are obtained by the business are of two types, i.e. long-term assets and short-term assets. On this basis, the investment decision is also divided into two parts:

(i) Long-term Investment Decision: This is also known by a different name which is the Capital Budgeting Decision. It relates to the investment in long-term assets. For example, buying a new machine. For the same purpose, the finance manager has to make a comparative study of various alternatives (according to the situations) available in the market on the basis of their cost and profitability. These decisions are very important as they affect the earning of the business over the long run.

(ii) Short-term Investment Decision: This is referred to as Working Capital Management. It relates to the investment in short-term assets, such as cash, stock, debtors, etc. The finance manager has to ensure that there is sufficient investment in these assets as they affect the liquidity position of the business. For the same purpose, the relative profitability and liquidity of these assets are compared.

  •  Factors Affecting Investment Decisions

Following factors affect the long-term and short-term investment Decision-

A. Cash Flows of the Project: We know investment decision (capital budgeting decision) is related to investment in long-term assets. The term assets basically involves both cash outflows and cash inflows over a series of years. The amount needed for investment is known as cash inflows. Both of these need to be analyzed carefully before finalizing the investment.

B. The Rate of Return: A project may not be profitable as compared to others. The criterion to decide the profitability of various projects is their respective rate of returns. The rate of return is calculated on the basis of the expected return of the project and the risk attached with it. If two projects are of the same risk class, the project having a higher rate of return will be accepted.

C. Investment Criteria Involved: There may be many criteria of the investor while investing in the long-term assets. These are funds involved, rate of interest, rate of return, cash flow, etc. All these factors influence the decision to go for a particular investment or not. For the same purpose, capital budgeting techniques are applied and accordingly decisions are taken.

[B]  Short-term Investment Decision

Following factors affect the short-term investment decisions:

This decision is related to working capital management. Keeping an adequate amount of the working capital at all times in the business is called management of the working capital. Adequate amount means that the amount of working capital should neither be more nor less than required. Both of these situations are harmful. If the amount of the working capital is more than required, it will no doubt increase liquidity but decrease profitability. For instance, if a large amount of cash is kept as the working capital then this excess cash will remain idle and cause profitability to fall. On the contrary, if the amount of cash and other current assets is very little, then a lot of difficulties will have to be faced in meeting daily expenses and making payment to the creditors. Thus, the objective of management of working capital is so determined optimum amount of both the current assets and current liabilities so that the profitability of the business remains intact and there is no fall in liquidity. In short, liquidity and profitability are the main factors which affect the short-term investment decision.

2. Financing Decision

It refers to the determination as to how the total funds required by the business will be obtained from various long-term sources (the fund is basically used for investment purpose). Long-term financial sources chiefly include equity share capital, preference share capital, retained earning, debenture, long-term loan, etc.
An analysis of the cost and benefit of all the sources is made. For example, Debt Capital (it includes both the debenture and long-term loan) is the cheapest of all the sources. However, the regular payment of interest and refund of capital is a constant burden on the company. On the other hand, a company is free in respect of the payment of dividend and refund of equity share capital but because of the presence of a great number of equity shareholders, there is a possibility of the control getting lax. Apart from this, the equity share capital is the costliest of them all. In this way, after making an analysis of various factors, the proportion of long-term sources of capital is determined.

  • Factors Affecting Financing Decision 

The following factors affect the financing decision:

1. Cost: The cost of all the sources of finance is different. The rate of interest on the debt, fixed rate of dividend to be paid on preference share capital and the expectations of the shareholders on the equity share capital are in the form of costs. If the situations happen to be favorable, the benefit of cheap finance can be availed of by choosing debt capital.

2. Risk: Debt capital is most risky and from the point of view it should not be used.

3. Floatation Cost: From the point of view of floating costs, retained profit is the most appropriate source. Therefore, its use should be made.

4. Cash Flow Position: If the cash flow position of the company is good, the payment of interest on the debt and the refund of capital can be easily made. Therefore, in order to take advantage of cheap finance, debt can be given priority.

5. Level of Fixed Operating Costs: In business, there are mainly two types of costs:

(a) Fixed operating cost, example- rent of the building, payment of the salary, insurance premium, etc.
(b) Fixed Financial Costs, example- interest on the debt, etc. If the level of fixed operating costs is in excess, it is better to keep the fixed financial costs should not be used. On the contrary, if the level of fixed operating cost is low, the use of debt capital is profitable.

6. Control Consideration: The ultimate control of the company is that of the equity shareholders. Greater the number of equity shareholder, the greater will be the control in the hands of more people. This is not a good situation. 

7. State of Capital Market: Bullish time brings more profit. Therefore, people like to invest more in equity shares. On the contrary, profits are low when there is a bear market. The people mainly give preference to debt capital for the purpose of earning more profits. Therefore, the source of finance should be chosen keeping in view the position of the market.

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