Financing Decision, Dividend Decision and Liquidity Decision

The second major decision of the firm is the financing decision. The financial manager is concerned with determining the best financing mix or capital structure. If a company can change its total valuation by varying its capital structure, an optimal financing mix would exist, in which market price per share could be maximized. The term capital structure refers to the proportion

of debt (fixed interest source of financing) and equity capital (variable – dividend securities / source of funds). The financial managers must strive to obtain a best financing mix as the optimal capital structure. The firm’s capital structure is considered optimum when the market value of share is maximized and overall cost of capital is minimized. The use of debt affects return and risk of the shareholders; it may increase higher return to the shareholder with higher financial risk. A proper balance between debt and equity to trade – off risk and return to the shareholders is necessary.

Dividend decision is the third major function of finance. The dividend decision includes the percentage of earnings paid to stockholders in cash dividends, the stability of absolute dividends about a trend, stock dividends and splits, and the repurchase of stock. The dividend-payout ratio determines the amount of earning retained in the firm and must be evaluated in the light of the objective of maximizing shareholder wealth. The value, if any of a dividend to investor must be balanced against the opportunity cost of the retained earnings lost as a means of equity financing. This is an important task of a financial manager under different finance functions. The final decision will depend upon the preference of the shareholders and investment opportunity available within the firm. But whatever may be the policy of the firms, the policy should be determined in terms of its impact on the shareholder’s value. Thus, we see that the dividend decision should be analyzed in relation to the financing decision.

Liquidity decision is concerned with the working capital management or current assets management. It is yet another important finance function. Current assets should be managed to save the firm from the illiquidity and insolvency. If the firm does not invest sufficient funds in current assets, it may become illiquid and may not have ability to meet its current obligations and, thus invite serious risk of bankruptcy. Its current assets are too large, profitability is adversely affected. Therefore there must be neither too low nor too high current assets in the organization. A proper trade-off should be there between liquidity and profitability, while managing the current assets.