Financing Decision refers to the determination as to how the total funds required by the business will be obtained from various long-term sources. Long-term financial sources chiefly include equity share capital, preference share capital, retained earnings, debentures, long-term loan, etc.
The following factors affect the financing decision:
(i) Cost of Funds: Different financial sources have different cost like interest on debt, dividend of shares. A company chooses a source which proves to be the cheapest.
(ii) Risk: From companies point of view debt is more risky than equity. So, company should analyse its financial risk bearing capacity and choose a source accordingly.
(iii) Floatation Cost: Higher the floatation cost of a source, less attractive it appears to the management.
(iv) Cash Flow Position: A stronger cash flow position makes debt financing more viable than funding through equity.
(v) Level of Fixed Operating Cost: If a business has high fixed operating costs (For example, rent, insurance premium etc.), it should opt for less fixed financing cost (interest) by using less debt financing. Similarly, if fixed operating cost is less, more debt financing can be done.
(vi) Control Consideration: Issue of more equity may lead to dilution of management control over the business companies which may afraid them of a takeover bid. So it may prefer debt to equity.
(vii) State of Capital Markets: A depressed capital market makes issue of equity shares a difficult and less attractive source of finance in comparison to debt. Similarly, a rising capital market makes equity more viable source of finance than debt.
(viii) Return on Investment: If the ROI for a company is higher, it will use more debt to take advantage of trading on equity.
(ix) Tax Rate: Since interest is a tax deductible expense, a higher tax rate makes debt relatively cheaper and increases its attraction vis-a-vis equity.
(x) Flexibility: If a firm uses its debt potential to the full capacity, it losses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
(xi) Regulatory Framework: Different sources of finance have different regulatory framework provided by the law. The relative ease with which these norms can be met has a good effect on the choice of the source of finance.