Page 3 - Lesson Note 2

The shareholders’ funds refer to the equity capital and the retained earnings.

Borrowed funds refer to the finance raised through debentures or other forms of
debt. A firm has to decide the proportion of funds to be raised from either source,

based on their basic characteristics. Interest on borrowed funds has to be paid
regardless of whether or not a firm has earned a profit. Likewise, the borrowed

funds have to be repaid at a fixed time.

The risk of default on payment is known as financial risk which has to be

considered by a firm likely to have insufficient shareholders to make these fixed
payments. Shareholders’ funds, on the other hand, involve no commitment

regarding the payment of returns or the repayment of capital.

A firm, therefore, needs to have a judicious mix of both debt and equity in

making financing decisions, which may be debt, equity, preference share capital,
and retained earnings. The cost of each type of finance has to be estimated. Some

sources may be cheaper than others.

For example, debt is considered to be the cheapest of all the sources, tax
deductibility of interest makes it still cheaper. Associated risk is also different for
each source, e.g., it is necessary to pay interest on debt and redeem the principal

amount on maturity. There is no such compulsion to pay any dividend on equity
shares. Thus, there is some amount of financial risk in debt financing.

The overall financial risk depends upon the proportion of debt in the total

capital. The fund raising exercise also costs something. This cost is called
floatation cost. It also must be considered while evaluating different sources.
Financing decision is, thus, concerned with the decisions about how much to be

raised from which source. This decision determines the overall cost of capital and
the financial risk of the enterprise.

Factors Affecting Financing Decisions

The financing decisions are affected by various factors. Important among them

are as follows: