Financial managers are involved in activities that can be categorized into three key decision areas. Their performance should be judged on how well their companies do in these areas of financing.
The Investment Decision
This decision deals with determining what assets and projects the company will put money into. It is called the capital budgeting decision.
A manager must possess the right skills or have human resource skills at his disposal in order to carefully evaluate projects before making a decision on whether to fund them. Some of the factors affecting capital budgeting decisions include the cash-flows of projects, their rate of return on investment, the risks, or variability of cash-flows, as well as availability of other resources besides money (Brigham & Houston, 2019).
Capital budgeting decisions are crucial for a number of reasons.
a) First, they involve huge amounts of money and therefore, it is absolutely important that managers get them right
b) They affect the long-term growth of firms; the success of such investments is what determines a company’s ability to grow its balance sheet size
c) Such decisions are mostly irreversible in the short term. For instance, a decision to acquire a new manufacturing plant or to acquire another company cannot be rescinded easily.
This is the choice of source of funds for a company. These include issue of ordinary shares, loans, bonds, and so forth.
The amount and source of financing has far-reaching implications on the company because each source has to be repaid. Getting the right mix into the capital structure is an art that managers need to learn in order to succeed. For instance, it would not be prudent to finance long-term projects using short term sources of funds such as a bank overdraft. The repayment period and structure should match the lifetime of the project or investment being financed.
Besides the repayment period, there are some other factors that affect the financing decision;
a) Cost- Each source of funds, whether owner’s capital or debt, has a cost. The cost should not exceed the expected rate of return on the project being financed.
b) Flotation costs- These are the costs managers incur in trying to raise funds from a particular source. For instance, when issuing shares to the public for the first time, the costs incurred during the IPO process are flotation costs. Similarly, when getting a bank loan, there are flotation costs incurred as they assess a company’s credit worthiness.
c) Level of Control Given Up- A company has to considered how much financiers want to get involved in decision making. For instance, a private company that goes public has to involve shareholders in decision making through annual general meeting and representation on the Board as well. Similarly, banks that offer huge amounts of financing to a particular project may want a seat at the Board as a requirement before releasing funds. Managers must consider whether they are willing to cede such ground.
d) Effects on Cash-flow- There are sources of funds that require regular cash repayments e.g bank loans, debentures, and bonds. A company must consider whether it will be in a position to generate such cash-flow regularly.
This is the final decision usually taken by managers. It involves deciding whether to and how much to pay to shareholders from net earnings of a firm. There is also a question of in which form to pay dividends. There is an option of cash payouts, bonus shares, promissory notes, and so forth.
The managers must make shareholders understand their vision and why there are proposing a particular dividend policy. Young and fast-growing companies will often re-invest as much money as they can into new areas of growth as opposed to paying dividends. Mature companies on the other hand often attract shareholders looking to get regular dividends (Brigham & Houston, 2019).
Brigham, E. F., & Houston, J. F. (2019). Fundamentals of financial management. Boston, MA, USA: Cengage Learning.