The Financing Decision

The financing decisions are decisions concerned regarding the method that are used to raise funds which would be used for making acquisitions. The financing decisions are decisions concerning the liabilities and stockholders' equity side of the firm's balance sheet, such as a decision to issue bonds.

The financing decisions involve various factors. They are determining the proper amount of funds to employ in a firm, selecting projects and capital expenditure analysis, raising funds on the most favorable terms possible and finally managing working capital such as inventory and accounts receivable. The goals of corporate finance can be achieved only when the corporate investment is financed appropriately. The financing mix will make an impact the valuation. The company should therefore identify an optimal mix of financing i.e. the one which results in maximum value.

The sources of finance are usually comprised of a combination of debt and equity financing. A project that is financed through debt results in a liability and obligation. When the projects are financed through equity is less risky with respect to cash flow commitments. The cost of equity is always higher than the cost of the debt. The equity financing may result in an increased hurdle rate which will offset any reduction in the cash flow risk. The management of the company must match the financing mix to the asset that is being financed.

One of the theories as to how the firms make their financing decisions is the Pecking Order Theory. Under this theory the firms should avoid external financing if they have an availability of internal financing option. They also avoid equity financing if they have an option of debt financing at lower interest rates. Another theory which helps firms in financial decision is the Trade-off theory where firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their decisions.

Questions

• What is financing decision?
• What are the factors to be considered for a financing decision?