Financial Management Test - 3

Financial planning involves identifying the sources from where the funds can be obtained and ensuring that the required funds are available to the firm as and when required. It involves planning with regard to both short term and long term.

Financing decisions involve decisions with regard to the volume of funds and identifying the sources of funds. There can be two main sources of funds for a firm, namely, debt and equity. Financing decision involves deciding how much of funds would be raised from each.

Debt involves financial risk in the sense that there is compulsion to repay the debt amount in a fixed period of time. On the other hand, there is no such risk in case of equity. Accordingly, higher the proportion of debt in total capital, higher will be the financial risk.

If a firm has high fixed operating cost, then the fixed financing cost must be lowered. For this, debt must be lowered.

In all other situations mentioned in the question, debt financing would be preferred over equity financing.

Financial management deals with optimally procuring funds at a reduced cost, effectively deploying funds, and at the same time, maintaining the availability of funds as and when required. However, it discourages taking high risks; rather, the risk must be kept under control. 

Hence, the statement given as taking high risk so as to attain high returns is not correct with regard to objectives of financial management.

Debt is the cheapest of all sources of funds. Moreover, the interest on debt is tax deductable, which further reduces the cost of debt.

It must opt for debt. Unlike equity, debt involves financial risk in the sense that is a compulsion to repay the debt amount along with interest. However, management’s control is not diluted in case of debt as happens in case of equity.

Dividend decision refers to the decision of what proportion of total profits is to be distributed as dividends to shareholders. The dividend decision depends on factors such as stability in earnings, opportunities of growth, policy of taxation, preference of shareholders, legal and contractual constraints, access to capital market etc.

One of the factors affecting divided decision is the growth opportunities of the firm. If the firm foresees greater growth opportunities, then it would retain a greater proportion of profits rather than distributing it as dividends to shareholders.

Financial risk refers to the risk that the borrowed funds would not be repaid. Debt involves large financial risk. On the other hand, equity and retained capital do not involve any such risk.

The given situation describes dividend decision. Dividend decision refers to the decision of what proportion of total profits is to be distributed as dividends to shareholders.