Financing Decision

The second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is·with the financing-mix or capital structure or leverage, The term capital structure refers to the proportion of debt (fixed-interest sources of financing) and equity capital (variable-dividend securities/source of funds). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. There are two aspects of the financing decision. First, the theory of capital structure which shows the theoretical relationship between the employment debt and the return to the shareholders, The use of debt implies a high return to the shareholders 25 also the financial risk. A proper balance between debt and equity to ensure a trade-off between risk and return to the shareholders is necessary, A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure. Thus, one dimension of the financing decision whether there is an optimum capital structure and in what proportion should funds be raised to maximize the return to the shareholders? The second aspect of the financing decision is the determination of to an appropriate capital structure given the facts of a particular case, Thus, the financing decision covers two interrelated aspects: (1) the capital structure theory, and (2) the capital structure decision.

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