Financial management is concerned with the acquisition, financing, and management of assets with some overall goals in mind. Thus, the decision function of financial management can be broken down into three major areas: Investment decisions, Financing decisions; and Asset management decisions. Objectives
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DECISION AREAS IN BUSINESS FINANCE
By the end of this session, you should be able to:
(a) explain the investment decision of a firm
(b) discuss the financing decisions of the firm
(c) explain the asset management decisions of the firm
(d) outline the working capital management decisions of a firm
5.1 Investment Decision (capital budgeting)
The investment decision is the most important of the firm’s three major decisions when it comes to value creation. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make.
Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. More often than not, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns).
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It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project.
For example, how much of the firm’s total assets should be devoted to cash or to inventory? Also, the flip side of investment – disinvestment – must not be ignored. Assets that can no longer be economically justified may need to be reduced, eliminated, or replaced.
5.2 Financing Decision (capital structure)
The second major decision of the firm is the financing decision. Here the financial manager is concerned with the makeup of the liabilities and the equity side of the statement of financial position.
If you look at the mix of financing for firms across industries, you will see marked differences. Some firms have relatively large amounts of debt, whereas others are almost debt-free. Does the type of financing employed to make a difference? If so, why? And, in some sense, can a certain mix of financing be thought of as best?
In addition, dividend policy must be viewed as an integral part of the firm’s financing decision. The dividend-pay-out ratio determines the number of earnings that can be retained in the firm.
Retaining a greater amount of current earnings in the firm means that fewer Ghana cedis will be available for current dividend payments. The value of the dividends paid to shareholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing.
Once the mix of financing has been decided, the financial manager must still determine how best to physically acquire the needed funds.
The mechanics of getting a short-term loan, entering into a long-term lease arrangement, or negotiating a sale of bonds or shares must be understood.
5.3 Asset Management Decision
The third important decision of the firm is the asset management decision.
Once assets have been acquired and appropriate financing provided, these assets must still be managed efficiently. The financial manager is charged with varying degrees of operating responsibility for existing assets.
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These responsibilities require that the financial manager be more concerned with the management of current assets than with non-current assets. A large share of the responsibility for the management of non-current assets would reside with the operating managers who employ these assets.
5.4 Dividend Decision
The financial manager must decide whether profit should be distributed or retained, or distribute a proportion and retain the balance. The policy (dividend policy) decision must be within the context of the business’ objectives.
5.5 Working Capital Management
It refers to a business’ short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing a business’ working capital is a day-to-day activity that ensures the business has sufficient resources to continue its operations and avoid costly interruptions. In view of this, the following questions must be answered:
• How much cash and inventory should be kept on hand?
• Should the business sell on credit?
• How will the business obtain short-term credit?
• If we borrow short-term, how and when should we do it?
At the end of this session, studied the decision areas in finance. Investment decisions, financing decisions, asset management decisions, dividend decisions and working capital management decisions were explained in this session. Do you see why we said finance is a living subject that we cannot throw away?