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Posted on Dec 25, 2022 in Computers

Investment decision relates to the determination of total amount of assets to be held in the firm ,the composition of these assets and the business risk complexions of the firm as perceived by its investors .It is the most important financial decision that the firm makes in pursuit of making shareholders wealth. Investment decision can be classified under two broad groups. * Long –term investment decision i.e. Capital budgeting. * Short-term investment decision i.e. Working Capital Management. The evaluation of long-term investment decisions or investment analysis to be consistent with the firm’s goal involves the following three basic steps. 1. Estimation or determination of cash flows. 2. Determining the rate of discount or cost of capital. 3. Applying the technique of capital budgeting to determine the viability of the investment proposal. 

Estimation of relevant cash flows. If a firm makes an investment today ,it will require an immediate cash outlay, but the benefits of this investment will be received in future .There are two alternative criteria available for ascertaining future economic benefits of an investment proposal- 
1. Accounting profit 2. Cash flow

Determining the rate of discount or cost of capital. It is the evaluation of investment decisions on net present value basis i.e. determine the rate of discount .Cost of capital is the minimum rate of return expected by its investors

. Applying the technique of capital budgeting to determine the viability of the investment proposal.

CAPITAL BUDGETING PROCESS : A Capital Budgeting decision involves the following process : 
(1) Identification of investment proposals. 
(2) Screening the proposals. 
(3) Evaluation of various proposals. 
(4) Fixing priorities. 
(5) Final approval and preparation of capital expenditure budget. (6) Implementing proposal. 
(7) Performance review

ESTIMATION OF COMPONENTS OF COST OF CAPITAL Components of cost of capital includes individual source of finance in business. From the viewpoint of capital budgeting decisions, the long term sources of funds are relevant as they constitute the major sources of financing the fixed assets. In calculating the cost of capital, therefore components include- 1. Long term debt (including Debentures) 2. Preference capital 3. Equity Capital. 4. Retained Earnings 5. Weighted Average Cost of Capital 6. Marginal Cost of Capital

Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net Present Value method for investment proposals. So, it is very useful in capital budgeting decisions.
 ii) Capital structure decisions: An optimal capital structure is that structure at which the value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure. iii) Evaluation of financial performance: Cost of capital is used to evaluate the financial performance of top management. The actual profitability is compared to the expected and actual cost of capital of funds and if profit is greater than the cost of capital the performance may be said to be satisfactory. iv) Other financial decisions: Cost of capital is also useful in making such other financial decisions as dividend policy, capitalization of profits, making the rights issue, etc. Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return

SHORT TERM FUNDS : Short term funds are usually required for working capital; to operate the project after it is completed. The working capital consists of the margin to be provided by the entrepreneur and the bulk of the balance is borrowed from a commercial bank or some other source as short term finance. 
  1.  Commercial banks, 2. The type of debentures issued for meeting working capital requirements are usually then on-convertible debentures. 3. Public Deposit 4. Commercial Paper 5. Supplier’ Credit 6. Foreign currency funds etc.



Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net Present Value method for investment proposals. So, it is very useful in capital budgeting decisions. ii) Capital structure decisions: An optimal capital structure is that structure at which the value of the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing optimal capital structure. iii) Evaluation of financial performance: Cost of capital is used to evaluate the financial performance of top management. The actual profitability is compared to the expected and actual cost of capital of funds and if profit is greater than the cost of capital the performance may be said to be satisfactory. iv) Other financial decisions: Cost of capital is also useful in making such other financial decisions as dividend policy, capitalization of profits, making the rights issue, etc. Explicit and Implicit Cost: Explicit cost of any source of finance is the discount rate which equates the present value of cash inflows with the present value of cash outflows. It is the internal rate of return

  1. Equity share capital is a basic source of finance for any Company. It represents the ownership interest in the company. The characteristics of equity share capital are a direct consequence of its position in the company’s control, income and assets

  3. The preference share capital is also owner’s capital but has a maturity period. In India, the preference shares must be redeemed within a maximum period of 20 years from the date of issue. The rate of dividend payable on preference shares is also fixed

  5. Debentures A bond or a debenture is the basic debt instrument which may be issued by a borrowing company for a price which may be less than, equal to or more than the face value.

  7. Lease and Hire Purchase Instead of procuring funds, and purchasing the equipment, a firm can acquire the asset itself on lease

  9. Official Foreign Source of Finance

  11. Term Loans This is also an important source of long-term financing. There are different financial institutions (National level as well as State level) which provide financial assistance for taking up projects
  12. Foreign Direct Investment (FDI)

Capital Structure Theory The capital structure of a company refers to a combination of the long-term finances used by the firm. The theory of capital structure is closely related to the firm’s cost of capital. The decision regarding the capital structure or the financial leverage or the financing is based on the objective of achieving the maximization of shareholders wealth. To design capital structure, we should consider the following two propositions: (i) Wealth maximization is attained. (ii) Best approximation to the optimal capital structure.  

Factors Determining Capital Structure (1) Minimization of Risk : (a) Capital structure must be consistent with business risk. (b) It should result in a certain level of financial risk. (2) Control : It should reflect the management’s philosophy of control over the firm. School of Distance Education Financial Management Page 39 (3) Flexibility : It refers to the ability of the firm to meet the requirements of the changing situations. (4) Profitability : It should be profitable from the equity shareholders point of view. (5) Solvency : The use of excessive debt may threaten the solvency of the company. (6)Financial leverage or Trading on equity. (7) Cost of capital. (8)Nature and size of the firm.

TYPES OF DIVIDENDS Dividends may be declared in the form of cash, stock, scripts, bonds and property. 1. Cash Dividends Cash dividend is, by far, the most important form of dividend. In cash dividends stock holders receive cheques for the amounts due to them. Cash generated by business earnings is used to pay cash dividends  2. Stock Dividends 3. Stock Splits  4. Stock Splits 5. Property Dividends

FACTORS AFFECTING DIVIDEND POLICY :  1.General state of economy , . Legal restrictions

Internal factors:  Desire of the shareholders , Financial needs of the company , Desire of control ,  Liquidity position

TYPES OF DIVIDEND POLICY : The various types of dividend policies are discussed as follows: 1.
 Regular Dividend Policy : Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically weaker persons prefer to get regular dividends.
 Stable Dividend Policy : t means payment of certain minimum amount of dividend regularly

Irregular Dividend Policy Some companies follow irregular dividend payments on account of the following: a. Uncertainty of earnings. b. Unsuccessful business operations. c. Lack of liquid resources. d. Fear of adverse effects of regular dividends on the financial standing of the company. 
 No Dividend Policy A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth. 5. Residual Dividend Policy When new equity is raised floatation costs are involved. This makes new equity costlier than retained earnings. Under the Residual approach, dividends are paid out of profits after making provision for money required to meet upcoming capital expenditure commitments

WORKING CAPITAL MANAGEMENT The term working capital is commonly used for the capital required for day-to-day working in a business concern, such as for purchasing raw material, for meeting day-to-day expenditure on salaries, wages, rents rates, advertising etc. But there are much disagreement among various financial authorities 

Working capital refers to the circulating capital required to meet the day to day operations of a business firm
 Gross Working Capital: It refers to the firm’s investment in total current or circulating assets. 2
. Net Working Capital: The term “Net Working Capital” has been defined in two different ways: i. It is the excess of current assets over current liabilities. This is, as a matter of fact, the most commonly accepted definition. Some people define it as only the difference between current assets and current liabilities. The former seems to be a better definition as compared to the latter. ii. It is that portion of a firm’s current assets which is financed by long-term funds. 
Permanent Working Capital: This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. In other words, it represents the current assets required on a continuing basis over the entire year. Tandon Committee has referred to this type of working capital as “Core current assets”.

DETERMINANTS OF WORKING CAPITAL: The factors influencing the working capital decisions of a firm may be classified as two groups, such as internal factors and external factors. The internal factors includes, nature of business size of business, firm’s product policy, credit policy, dividend policy, and access to money and capital markets, growth and expansion of business etc. The external factors include business fluctuations, changes in the technology, infrastructural facilities, import policy and the taxation policy etc

 Internal Factors 1. Nature and size of the business , Firm’s production policy ,  Firm’s credit policy ,  Availability of credit  , Growth and expansion of business , Profit margin and dividend policy ,  Operating efficiency of the firm,   Co-ordinating activities in firm

II. External Factors 1. Business fluctuations  , Changes in the technology,. Import policy , Infrastructural facilities ,  Taxation policy

MEASUREMENT OF WORKING CAPITAL: There are 3 methods for assessing the working capital requirement as explained below: a) Percent of Sales Method Based on the past experience, some percentage of sales may be taken for determining the quantum of working capital b) Regression Analysis Method The relationship between sales and working capital and its various components may be plotted on Scatter diagram and the average percentage of past 5 years may be ascertained. This average percentage of sales may be taken as working capital. Similar exercise may be carried out at the beginning of the year for assessing the working capital requirement. This method is suitable for simple as well as complex situations. c) Operating Cycle Method: It is also known as working capital cycle. Operating cycle is the total time gap between the purchase of raw material and the receipt from Debtors.