Question 1 (a)

The investment, financing and dividend decisions are interrelated

7 marks

Time to write: About 14 minutes

From an older CBCS paper

Question

Question 1 (a) · 7 marks

The investment, financing and dividend decisions are all interrelated. Comment.

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

14 minfor 7 marks

Read from the question

CommentA statement to judge: take a stand on it in your first line, give your reasons, and come back to it at the end.

Write it in this order

Read; underline the asks; jot your points 1 min
1 The three decisions and V = f I, F, D 2 marks 3 min
2 How each pair of decisions is linked 3 marks 5 min
3 Illustration and conclusion 2 marks 3 min
Check: every ask answered, key terms underlined 2 min

123

Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 14 minutes for 7 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.

The three decisions. Financial management is usually described through three decisions, and the value of the firm is written as a function of all three, V = f(I, F, D).

Decision	What it settles	Source
Investment (I)	Which assets the funds are put into: selection of projects through capital budgeting, and the level of working capital
Financing (F)	From where the funds are raised: the balance between equity and debt, and the risk that goes with it
Dividend (D)	How much of the profit is paid out and how much is kept in the business

Why they are interrelated. The text itself describes the three as interrelated; the investment and financing decisions arise in any kind of organisation, while the dividend decision arises only in a profit-making one. Each pair of decisions touches the third:

Link	How one decision shapes the other
Investment and financing	A project is judged by discounting its cash flows at the cost of capital, which comes from the financing mix; the same cost of capital is also used to compare the sources of finance. A larger investment programme raises the amount of funds to be found, and heavy borrowing to find them adds risk for the equity holders.
Dividend and financing	Profit that is not paid out is itself a source of finance, so the retention part of the dividend decision is also a financing decision. A firm that pays out most of its earnings has to turn to new debt or new shares for its needs.
Dividend and investment	Retained earnings can be invested in assets that keep the firm growing, and the decisions on whether, how much and when to pay dividends all bear on its future growth plans.

Illustration (our own figures). A company earns a profit after tax of ₹50 lakh and has a project costing ₹80 lakh.

Payout decision	Dividend (₹ lakh)	Retained (₹ lakh)	Funds to be raised outside (₹ lakh)
60% of profit paid out	30	20	60
20% of profit paid out	10	40	40

A higher payout therefore means a larger outside issue of debt or shares (a financing decision). Retained profit is a source with no explicit cost, while an outside issue brings its own cost, including the issue expenses paid to intermediaries, and that cost is part of the cost of capital at which the project's cash flows are discounted (an investment decision). A lower payout lessens that need but gives shareholders less cash now. No one decision can be fixed without looking at the other two.

Conclusion. All three decisions are pursued for one objective, maximising the shareholders' wealth, so a finance manager takes them jointly. The investment decision sets the funds needed, the financing decision fixes their cost and risk, and the dividend decision divides profit between shareholders and the business; a change in any one alters what the shares of the firm are worth.

Where the 7 marks sit

#	Component	Marks
1	The three decisions and V = f(I, F, D)	2
2	How each pair of decisions is linked	3
3	Illustration and conclusion	2
	Total	7

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