Question 1
The three financial decisions and how they are interrelated
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 1 · 18.75 marks"Financial management is concerned with solving the three major decisions that a firm must make." What are the three decisions, and how are they interrelated?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks.
The paper prints only the total marks. The split below is ours.
Write it in this order
- Read; underline the asks; jot your points 2 min
- 1 Investment decision: capital budgeting and working capital 5 marks 9 min
- 2 Financing decision 4 marks 7 min
- 3 Dividend decision 3.8 marks 7 min
- 4 How they are interrelated, with an illustration 6 marks 11 min
- Check: every ask answered, key terms underlined 2 min
Short on time? Trim steps 1–4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Financial management deals with three major problems, corresponding to the questions of investment, financing and dividend decisions: procuring funds at the lowest cost, investing them profitably, and distributing returns to the shareholders.
- Investment decision. It concerns the asset composition of the firm: where to invest.
- Capital budgeting: investment in long-term assets whose benefits come over many years, such as buying an asset, choosing between alternatives, buying or leasing, or acquiring a firm. Its aim is to pick assets worth more than their cost.
- Working capital management: investment in current assets (inventory, credit to customers), balancing profitability against liquidity.
- Financing decision. When, where from and how to raise the funds the investments need. The two main sources are shareholders' funds and borrowed funds, and the central issue is the proportion of each, the firm's capital structure.
- Dividend decision. How much of the profit to distribute to the shareholders and how much to retain for reinvestment, so as to satisfy shareholders' expectations while funding growth.
All three are taken with one aim: to maximise the shareholders' wealth, that is, the market value of the shares.
Interrelation. The three decisions are not independent. An investment proposal can be accepted only if it earns more than the cost of the funds raised for it, which depends on the financing decision; and a decision to retain more profit (the dividend decision) is also a decision to finance investment internally. The finance manager therefore takes them jointly, so that together they maximise the value of the firm.
How the interrelation works in practice
| Link | How one decision constrains another |
|---|---|
| Investment → financing | The size of the investment fixes how much must be raised, and its risk affects the return investors require and the terms on which finance can be raised, and so the mix and cost of funds. |
| Financing → investment | The cost of capital set by the financing decision is the hurdle rate (the discount rate) used to accept or reject investment proposals; cheaper finance makes more projects acceptable. |
| Dividend → financing | Every rupee paid as dividend is a rupee not retained, which must be replaced by outside finance if the investments go ahead; retention is internal financing. |
| Investment → dividend | A firm with many profitable opportunities (return above the cost of capital) pays less; a firm with few pays more. |
| All three → value | Together they fix the firm's expected cash flows and their risk, and so the market price of the share. |
Illustration. A firm earning ₹10 lakh has a project needing ₹8 lakh that earns more than its cost of capital. If it pays a dividend of ₹6 lakh, it must raise ₹4 lakh outside, by debt (changing its capital structure and risk) or by new shares (with flotation costs); if it retains ₹8 lakh, it pays only ₹2 lakh. The investment, financing and dividend choices are one joint decision, taken to maximise the shareholders' wealth.
Where the 18.75 marks sit
Suggested split of the 18.75 marks (inferred: any four questions of equal marks); the division among the components is ours.
| # | Component | Marks |
|---|---|---|
| 1 | Investment decision: capital budgeting and working capital | 5 |
| 2 | Financing decision | 4 |
| 3 | Dividend decision | 3.75 |
| 4 | How they are interrelated, with an illustration | 6 |
| Total | 18.75 |
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