What are Financing Decisions?
Financing decisions refer to the decisions that companies need to take regarding what proportion of equity and debt capital to have in their capital structure. This plays a very important role vis-a-vis financing its assets, investment-related decisions, and shareholder value creation. An integral part of financial decisions is the consideration of the cost of capital, which companies must take into account. For any investment worth undertaking, the expected return on capital must be greater than the cost of capital i.e. weighted average cost of capital (WACC). Further, the cost of capital is an important ingredient in the valuation of a company by investors.
The financing decision seeks to optimize the WACC by looking at a company’s capital structure, specifically the cost of equity and the cost of debt. If a company wants to create value for shareholders, it needs to ensure that it’s ROIC (Return on Invested Capital) is greater than the WACC. As part of financing decisions, companies aim to minimize their cost of funding while maintaining a stable credit rating and the ability to finance new projects.
Key Learning Points
- If a company wants to create shareholder value, its financing decisions should ensure that the WACC remains lower than its ROIC.
- To calculate the WACC, we need to calculate the cost of equity and cost of debt, and the proportion of debt and equity in the capital structure.
- Investment banks can help companies in their financing decisions.
Financing Decisions, Cost of Debt, Cost of Equity, and WACC
In order to establish the WACC of a business, we need to consider the cost of debt, which is based on market rates.
The formula is:
After establishing the cost of debt, we need to consider the cost of equity (Ke) – using the Capital Asset Pricing Model (CAPM)
Stated below is the CAPM Model, which is used to calculate the cost of equity:
Once we have these two components, we can bring them together to calculate the WACC (based on the long-term capital structure of a company). The formula for the same is:
Financing Decisions and Investment Banking
Investment banks can help companies in minimizing their cost of capital (WACC).
Corporate financing decisions usually involve equity capital, debt capital, and risk management, and investment banks offer a range of services related to these. Investment banks can provide advice such as accessing equity capital markets and guiding companies as to whether they should consider an Initial Public Offering (IPO) and how best to execute this. Regarding debt capital markets, they can assist in investment-grade and leveraged finance capital markets. Other decisions may be regarding structured finance and corporate derivatives. When companies think about capital, they need to consider foreign exchange rates when raising capital in different currencies, and interest rates for risk management and investment banks can offer experienced advice on this.
Financing Decisions, WACC, ROIC, Creating Value for Shareholders – Example
Given below is the calculation of WACC for Adidas. The post-tax cost of debt and cost of equity has already been given. The share price from its Public Information Book (February 11, 2019) was €199.50 (i.e. the current market price at that time). The number of current shares outstanding, 200.3 million, is also from the same source. The Equity at Market Value is equal to the product of the current market price and the number of current shares outstanding.
Next, we need the market value of debt. However, we use the book value of debt as a proxy number. They will not be too far apart from the underlying value of the debt. The book value of debt can be obtained from the balance sheet of the company and equals Short Term Borrowing + Other Current Financial Liabilities + Long Term Borrowings + Other non-current financial liabilities.
Finally, the WACC is calculated and one can view that the ROIC (23.9%) is significantly higher than the company’s WACC (7.3%). Therefore, we can conclude the company’s financing decisions are such that it is creating value for its shareholders.
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FAQs
There are three types of financial decisions- investment, financing, and dividend. Managers take investment decisions regarding various securities, instruments, and assets. They take financing decisions to ensure regular and continuous financing of the organisations.
What do you mean by financing decisions? ›
What is the Financing Decision? The Financing Decision is a crucial decision that is to be made by the financial manager, the decision is about the financing-mix of an organization. Financing Decision is focused on the borrowing and allocation of funds required for the investment decisions of the firm.
What are the 3 main decisions in finance? ›
When it comes to managing finances, there are three distinct aspects of decision-making or types of decisions that a company will take. These include an Investment Decision, Financing Decision, and Dividend Decision.
What are the 5 steps in the financial decision-making process? ›
Plan your financial future in 5 steps
- Step 1: Assess your financial foothold. ...
- Step 2: Define your financial goals. ...
- Step 3: Research financial strategies. ...
- Step 4: Put your financial plan into action. ...
- Step 5: Monitor and evolve your financial plan.
Personal circ*mstances that influence financial thinking include family structure, health, career choice, and age. Family structure and health affect income needs and risk tolerance. Career choice affects income and wealth or asset accumulation.
What are the four main 4 types of financial planning? ›
The four main types of financial planning are cash flow planning, tax planning, investment planning, and retirement planning. Each of these types of financial planning has different goals, concerns, and objectives.
How do you make a financing decision? ›
What are the four tips to making smart financial decisions?
- Tip 1: Understanding needs vs. wants.
- Tip 2: Creating a spending plan.
- Tip 3: Maximizing savings opportunities.
- Tip 4: Putting the plan into action and sticking with it.
Financing decisions deal with the question of how funds should be raised to acquire various assets. These decisions relate to the optimal capital structure of the firm in terms of debt and equity.
What is the difference between financing decisions and investment decisions? ›
Investment decisions revolve around how to best allocate capital to maximize their value. Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sell equity.
Why are financial decisions important? ›
They can influence an enterprise's ability to survive economic downturns, compete in the market, and achieve its long-term objectives. Decisions on investment, debt-equity mix, and dividend policy can affect company profits. Financial decisions can shape the rate and direction of a company's growth.
1. Assess your financial situation and typical expenses. An important first step is to take stock of your current financial situation. Even if you're not where you'd like to be, be honest with yourself about the income you're currently generating, savings you've accumulated and your general spending habits.
How to make smart financial decisions? ›
Here are some tips on how to make smart financial decisions : Understand your financial situation. This includes knowing your income, expenses, debts, and assets. You can use a budgeting tool or app to track your finances and get a clear picture of your financial health.
What is the smart thing that you can do for your money? ›
Create a Spending Plan & Budget
If you are spending more than you earn, you will never get ahead—in fact, it's a sure sign that your finances are headed for trouble. The best way to make sure that your income is greater than your expenses is to track your expenses for a month or two and then create a budget.
What is the order of financial decisions? ›
The pecking order theory states that a company should prefer to finance itself first internally through retained earnings. If this source of financing is unavailable, a company should then finance itself through debt. Finally, and as a last resort, a company should finance itself through the issuing of new equity.
What are the types of financial decisions? ›
There are three primary types of financial decisions that financial managers must make: investment decisions, financing decisions, and dividend decisions. In this article, we will discuss the different types of financial decisions that are taken in order to manage a business's finances.
What are the 4 aspects of financial management? ›
These four elements are planning, controlling, organising & directing, and decision making.
What are the 5 economic decisions? ›
Economic decisions involve production, distribution, exchange, consumption, saving, and investment of economic resources.
