FINANCING DECISION (FINANCING)

1. Introduction and Meaning

The financing decision is one of the three core decisions of financial management (the other two being investment and dividend decisions). It deals with how to raise funds for the business. Once the firm decides which projects to invest in (investment decision), it must determine the best way to finance those investments.

The financing decision involves choosing the right mix of debt (borrowed funds) and equity (owners’ funds) to finance the firm’s assets. This mix is called the capital structure.

Simple meaning: Where will we get the money from – from owners (shares, retained earnings) or from lenders (loans, debentures, bonds)?

2. Key Questions Answered by Financing Decision

• How much money is needed? – Determining the total fund requirement.
• From which sources? – Choosing between internal and external, long‑term and short‑term.
• In what proportion? – Deciding the debt‑equity mix.
• At what cost? – Minimising the overall cost of capital.
• With what risk? – Balancing financial risk (fixed interest obligations) against potential returns.

3. Features of Financing Decision

• Long‑term in nature – It affects the firm’s capital structure for many years.
• Involves trade‑off – Between risk and return, between cost and control.
• Affects cost of capital – The choice of sources determines the firm’s weighted average cost of capital (WACC).
• Influences flexibility – Some sources (like retained earnings) offer more flexibility than debt with restrictive covenants.
• Impacts shareholder wealth – A well‑chosen capital structure maximises the market value of shares.

4. Sources of Finance (Where to Get Funds)

Sources can be classified based on ownership, period, or source of generation.

A. Classification by Ownership

B. Classification by Time Period

C. Classification by Source of Generation

5. Capital Structure – The Debt‑Equity Mix

Capital structure refers to the combination of debt and equity used by a firm to finance its assets. It is expressed as a ratio.

Formula: Capital Structure = Debt / Equity

Factors Affecting Capital Structure

1. Cost of capital – Debt is usually cheaper than equity because interest is tax‑deductible, but it carries risk.
2. Risk – Higher debt increases financial risk (fixed interest payments).
3. Control – Issuing more equity dilutes existing owners’ control; debt does not affect control.
4. Tax rate – Higher corporate tax makes debt more attractive (interest tax shield).
5. Flexibility – Debt may have restrictive covenants; equity is more flexible.
6. Growth stage – Growing firms may rely more on equity; stable firms can use more debt.
7. Industry practice – Firms often follow the capital structure norms of their industry.

6. Cost of Capital

The cost of capital is the minimum rate of return that a firm must earn on its investments to satisfy its investors (shareholders and lenders). It is the “price” paid for using funds.

Components of Cost of Capital

• Cost of debt (Kd) – Interest rate paid on borrowed funds, adjusted for tax.
• Cost of preference shares (Kp) – Fixed dividend rate on preference shares.
• Cost of equity (Ke) – Expected return by equity shareholders (difficult to calculate directly).
• Cost of retained earnings (Kr) – Opportunity cost – the return shareholders could have earned if profits were distributed.

Weighted Average Cost of Capital (WACC)

WACC is the overall cost of capital, calculated as the weighted average of the costs of each source of funds.

Formula: WACC = Σ (Weight of each source × Cost of that source)

7. Financial Leverage (Trading on Equity)

Leverage means using borrowed funds to increase the return to equity shareholders. It is also called trading on equity.

Formula: Financial Leverage = EBIT / EBT
(Where EBIT = Earnings Before Interest and Tax; EBT = Earnings Before Tax)

8. Capital Structure Theories

Several theories explain how capital structure affects firm value.

• Net Income (NI) Approach: Assumes cost of debt (Kd) and cost of equity (Ke) are constant. As debt increases, WACC decreases, firm value increases.
• Net Operating Income (NOI) Approach: Assumes WACC is constant regardless of debt level. Firm value is independent of capital structure.
• Modigliani-Miller (MM) Approach: Without taxes: Firm value is independent of capital structure. With taxes: Debt provides a tax shield. More debt increases firm value.
• Traditional Approach (Realistic): Moderate use of debt initially lowers WACC. Beyond a point, financial risk increases and WACC starts increasing.

9. Leverage Ratios Used in Financing Decisions

10. Illustrative Problems

Problem 1: WACC Calculation

Total capital = ₹ 45,00,000

Problem 2: EBIT‑EPS Analysis (Leverage)

Plan A: All equity (20,000 shares)
Plan B: ₹ 10,00,000 equity (10,000 shares) + ₹ 10,00,000 debt @ 10% interest
EBIT = ₹ 3,00,000. Tax = 30%.

11. Summary – Financing Decision

• Financing decision: Choosing the right mix of debt and equity.
• Capital structure: Proportion of debt to equity.
• Cost of capital: Minimum return required by investors.
• WACC: Weighted average cost of all sources.

Practice Lab

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