Strategic Financial Decisions: Capital Budgeting & Working Capital

Posted on Aug 19, 2025 in Business Administration and Management (BAM)

Strategic Financial Decisions

Investment decisions relate to the determination of the total amount of assets to be held in a firm, the composition of these assets, and the business risk complexion of the firm as perceived by its investors. It is the most important financial decision a firm makes in pursuit of maximizing shareholder wealth.

Types of Investment Decisions

  • Long-term Investment Decisions: Also known as Capital Budgeting.
  • Short-term Investment Decisions: Also known as Working Capital Management.

Capital Budgeting: Long-Term Investment Analysis

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 of relevant cash flows.
  2. Determining the rate of discount or cost of capital.
  3. Applying capital budgeting techniques to determine the viability of the investment proposal.

1. 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 the future. Two alternative criteria are available for ascertaining future economic benefits of an investment proposal:

  • Accounting Profit
  • Cash Flow

2. Determining the Discount Rate or Cost of Capital

Evaluating investment decisions on a Net Present Value (NPV) basis involves determining the appropriate discount rate. The cost of capital is the minimum rate of return expected by investors.

3. Applying Capital Budgeting Techniques

This step involves using various capital budgeting techniques to assess the viability of an 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.

Components of Cost of Capital

Components of the cost of capital include individual sources of finance in a business. From the viewpoint of capital budgeting decisions, long-term sources of funds are relevant as they constitute the major sources for financing fixed assets. In calculating the cost of capital, components therefore include:

  1. Long-term Debt (including Debentures)
  2. Preference Capital
  3. Equity Capital
  4. Retained Earnings
  5. Weighted Average Cost of Capital (WACC)
  6. Marginal Cost of Capital

Uses of Cost of Capital

  • Capital Budgeting Decisions: The cost of capital is used for discounting cash flows under the Net Present Value (NPV) method for investment proposals, making it very useful in capital budgeting decisions.
  • Capital Structure Decisions: An optimal capital structure maximizes the firm’s value and minimizes the cost of capital, making the cost of capital crucial in designing an optimal capital structure.
  • Evaluation of Financial Performance: The cost of capital is used to evaluate the financial performance of top management. Actual profitability is compared to the expected and actual cost of capital of funds; if profit exceeds the cost of capital, performance is considered satisfactory.
  • Other Financial Decisions: The cost of capital is also useful in making other financial decisions such as dividend policy, capitalization of profits, and rights issues.

Explicit and Implicit Costs

The explicit cost of any source of finance is the discount rate that equates the present value of cash inflows with the present value of cash outflows. It is essentially the internal rate of return.

Sources of Long-Term Finance

  1. Equity Share Capital: A basic source of finance for any company, representing ownership interest. Its characteristics are a direct consequence of its position in the company’s control, income, and assets.
  2. Preference Share Capital: Also owner’s capital but with a maturity period. In India, 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.
  3. Debentures: A bond or debenture is a basic debt instrument that may be issued by a borrowing company for a price that may be less than, equal to, or more than its face value.
  4. Lease and Hire Purchase: Instead of procuring funds and purchasing equipment, a firm can acquire the asset itself on lease.
  5. Official Foreign Sources of Finance
  6. Term Loans: An important source of long-term financing. Various financial institutions (national and state level) provide financial assistance for projects.
  7. Foreign Direct Investment (FDI)

Capital Structure Theory

The capital structure of a company refers to the combination of long-term finances used by the firm. The theory of capital structure is closely related to the firm’s cost of capital. Decisions regarding capital structure, financial leverage, or financing are based on the objective of maximizing shareholder wealth.

To design an optimal capital structure, two propositions should be considered:

  1. Wealth maximization is attained.
  2. Best approximation to the optimal capital structure.

Factors Determining Capital Structure

  1. Minimization of Risk:
    • Capital structure must be consistent with business risk.
    • It should result in a certain level of financial risk.
  2. Control: It should reflect the management’s philosophy of control over the firm.
  3. Flexibility: It refers to the firm’s ability to meet the requirements of 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 company’s solvency.
  6. Financial Leverage or Trading on Equity
  7. Cost of Capital
  8. Nature and Size of the Firm

Dividend Policy

Types of Dividends

Dividends may be declared in the form of cash, stock, scrip, bonds, and property.

  1. Cash Dividends: By far the most important form of dividend. Stockholders receive checks for the amounts due to them. Cash generated by business earnings is used to pay cash dividends.
  2. Stock Dividends
  3. Stock Splits
  4. Property Dividends

Factors Affecting Dividend Policy

  1. General State of Economy
  2. Legal Restrictions
Internal Factors:
  • Desire of Shareholders
  • Financial Needs of the Company
  • Desire for 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. Investors such as retired persons, widows, and other economically weaker persons prefer to receive regular dividends.
  2. Stable Dividend Policy: This means payment of a certain minimum amount of dividend regularly.
  3. Irregular Dividend Policy: Some companies follow irregular dividend payments due to the following:
    1. Uncertainty of Earnings
    2. Unsuccessful Business Operations
    3. Lack of Liquid Resources
    4. Fear of Adverse Effects of Regular Dividends on Financial Standing
  4. No Dividend Policy: A company may follow a policy of paying no dividends presently due to an unfavorable working capital position or requirements for future expansion and growth.
  5. Residual Dividend Policy: When new equity is raised, flotation costs are involved, making new equity costlier than retained earnings. Under the residual approach, dividends are paid out of profits after making provision for funds required to meet upcoming capital expenditure commitments.

Working Capital Management: Short-Term Operations

The term ‘working capital’ is commonly used for the capital required for day-to-day operations in a business concern, such as purchasing raw materials, and meeting daily expenditures on salaries, wages, rent, rates, advertising, etc. However, there is much disagreement among various financial authorities regarding its precise definition.

Working capital refers to the circulating capital required to meet the day-to-day operations of a business firm.

Types of Working Capital

  1. Gross Working Capital: This refers to a 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:
    1. It is the excess of current assets over current liabilities. This is the most commonly accepted definition. Some define it as only the difference between current assets and current liabilities, but the former seems to be a better definition.
    2. It is that portion of a firm’s current assets which is financed by long-term funds.
  3. Permanent Working Capital: This refers to the minimum amount of investment in all current assets required at all times to carry out minimum business activities. In other words, it represents the current assets required on a continuing basis throughout the year. The Tandon Committee referred to this type of working capital as ‘Core Current Assets’.

Determinants of Working Capital

The factors influencing a firm’s working capital decisions can be classified into two groups: internal factors and external factors.

Internal Factors:

  1. Nature and Size of the Business
  2. Firm’s Production Policy
  3. Firm’s Credit Policy
  4. Availability of Credit
  5. Growth and Expansion of Business
  6. Profit Margin and Dividend Policy
  7. Operating Efficiency of the Firm
  8. Coordinating Activities in the Firm

External Factors:

  1. Business Fluctuations
  2. Changes in Technology
  3. Import Policy
  4. Infrastructural Facilities
  5. Taxation Policy

Measurement of Working Capital

There are three methods for assessing working capital requirements:

  1. Percent of Sales Method: Based on past experience, a percentage of sales may be used to determine the quantum of working capital.
  2. Regression Analysis Method: The relationship between sales and working capital and its various components can be plotted on a scatter diagram, and the average percentage of the past 5 years can be ascertained. This average percentage of sales can then be taken as working capital. A similar exercise can be carried out at the beginning of the year for assessing working capital requirements. This method is suitable for both simple and complex situations.
  3. Operating Cycle Method: Also known as the working capital cycle, the operating cycle is the total time gap between the purchase of raw material and the receipt of cash from debtors.

Sources of Short-Term Funds

  1. Commercial Banks
  2. Non-Convertible Debentures (issued for working capital)
  3. Public Deposits
  4. Commercial Paper
  5. Supplier’s Credit
  6. Foreign Currency Funds