Financial Management Test - 4

Short term investment decisions are also called working capital decisions.  These are concerned with the decisions about the inventories, debtors, bills receivable and level of cash etc. It affects the day to day working of the business.

Under dividend decision the finance manager decides how much to be distributed in the form of dividend and how much to keep aside as retained earning. This decision is also called residual decision because it is concerned with distribution of residual or left over income.

The cost that a company incurs when it makes a new issue of either stocks or bonds. Flotation costs include the costs of printing the certificates, paying the underwriters, government fees, and other associated costs etc.

The Investment decision refers to the decision of investing funds in different assets. It can be long term or short term. A Long term Investment decision is also called 'Capital Budgeting Decision' . It involves investing the finance in capital assets like making investment in a new machine to replace an existing one, etc. 

The funds raised through loans or borrowings are known as borrowed funds.  Main sources for raising borrowed funds are issue of debentures, public deposits, loans from commercial banks, etc.

Financial leverage refers to proportion of debt in overall capital. As debt is a cheaper source of finance but very risky.  More debt will increase earning only if the ROI is higher than the cost of debt.

Financial decisions include:

• Investment decision
• Financing decision
• Dividend decision

The funds which remain invested in the business for a longer period of time and generally, not refunded  during the life of the bisiness.  For example equity shares, retained earnings, reserves etc.

Companies with higher growth opportunities tend to retain more money out of their earnings so as to finance the required investments. Therefore, higher growth prospects result in lower dividend payment.

Retained earning is a part of profit which is not distributed among shareholders as dividends but is retained in the business for future use. It is also known as self financing. It is available free of cost for the business.

Short term investment decisions are the decisions related with the bills receivables, inventories, levels of cash and debtors etc.  These decisions are also known as working capital decisions.

Current assets are those assets which, in the normal routine of the business, get converted into cash or cash equivalents within one year e.g. inventories, debtors etc. Hence  these should be financed by both long term and short term libility.

Long term investment decision involves committing the finance on a long term basis. It is also known as capital budgeting decision.

Working capital refers to excess of current assets over current liabilities.Higher current ratio, higher risks, higher profits indicates large scale operation thus require large working capital.

Cost of Debt is affected by tax rate because Interest on Debt is a deductible expense. A higher tax rate, thus, makes debt relatively cheaper as compared to equity. For Example: If the firm borrows @10% and tax rate is @30%, then the after cost of debt will be @7%.

Fixed assets remains in the business for more than one year.  Decision to invest in fixed assets are irrevocable. Therefore these assets should be financed by Fixed Capital. These decisions are called capital budgeting decisions. Management of fixed capital involves allocation of firm's capital to different long term assets.

Financial planning is the process of estimating the fund requirement of a business and specifying the sources of funds. It decides how much to spend and on what to spend. Thus ensures optimal utilisation of funds.

Financial management is concerned with management decisions relating to optimal procurement of funds, investment of funds in long term and short term assets of the firm.  It is wider in scope as it includes financial planning also.

Investment decision relates to how the firm's funds are invested in different assets. The firm invests its funds in acquiring fixed assets as well as current assets.  When decisions are taken regarding fixed assets then it is called capital budgeting decisions.

• These decisions are based on expected rate of return and risks involved from each proposal
• When a proposal involves huge cash flow in return it expects to generate cash flows
• Capital budgeting techniques are applied to each proposal before selecting a particular project. Amount of investment, interest rate etc should keep in mind.

• Financial manager will compare the risk with cost involved and prefer moderate risk factor and cost effectiveness.
• Firm prefer securities which involve least floatation cost.
• Smooth and steady cash flow companies will prefer borrowed funds but when shortage of cash flow, they prefer owner's funds.

The process of estimating the fund requirement of a business and specifying the sources of funds is called financial planning. The objective of financial planning  are

• To ensure availability of funds whenever these are required
• To see that the firm does not raise resources unnecessarily

Financial leverage is the degree to which a company uses fixed-income securities such as debt. Therefore, financial leverage is favorable when the uses to which debt can be put generate returns (ROI) greater than the interest expense associated with the debt (Cost of Debt).

Earning : Dividends are paid out of current and previous year's earnings. More earning then high rate of dividend

Taxation policy : If tax rate is high then less dividend will be declared whereas tax rate is low then more dividend will be declared

Cash flow position: Paying dividend means outflows of cash.  In surplus cash then high rate of dividend. If shortage of cash then companies declare low dividend.

These are the assets which can be converted into cash and cash equivalents within one year in the normal routine of business. e.g. inventories, debtors, bills receivable etc.

The dividend decision involves how much of the profit earned by company is to be distributed to the shareholders and how much of it should be retained in the business for meeting investment requirement.  High earning, high cash flow, stable earning and low growth opportunities etc. affects the rate of dividend.

Financial planning means deciding in advance how much to spend, on what to spend according to funds at your disposal. In financial planning finance manager analyses various short term and long term investment  plans and selects the most appropriate.

Financial Risk refers to the chance that a firm will fail to meet its payment obligations. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders). Higher use of debt increases the fixed financial charges (Interest on Debt) of a firm. As a result, increased used of debt increases the financial risk of a firm

Long term investment decisions are also called capital budgeting decisions which include purchase of land and building, plant and machinery,change of technology, research and development and expenditure of advertising campaign etc. Inventory management comes under working capital management decisions.

Companies employ more of cheaper debt to enhance the EPS. It is called trading on equity. It also refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.