Financing and dividend decisions

The financing decision is about how much to raise from each long-term source: shareholders' funds (equity, retained earnings) or borrowed funds (debentures, loans).

Debt is usually the cheapest source, because interest is tax-deductible. But it brings financial risk: interest and repayments must be paid whatever happens. Raising funds also has a cost, called the floatation cost (for example, fees for issuing shares).

Factors affecting the financing decision: the cost of each source; its risk; floatation costs; the firm's cash flow position (strong cash flows can carry more debt); its fixed operating costs (if high, less debt); control (issuing new shares can dilute the owners' control, so a company afraid of a takeover prefers debt); and the state of the capital market.

The dividend decision is about how much of the profit after tax to distribute to shareholders as dividend, and how much to retain in the business.

Factors: the amount of earnings; the wish for stable dividends; growth opportunities (a growing firm keeps more profit to invest); cash flow; shareholders' preference; taxation of dividends; the stock market's reaction; access to the capital market (a firm that can raise money easily can pay more); and legal and contractual limits (lenders may restrict dividends).