Question 1 (a)
The three financial decisions and how they are related
5 marks
- Time to write
- About 10 minutes
Question
Question 1 (a) · 5 marks"Financial Management is concerned with solving three major decisions that a firm must make: the investment decision, the financing decision and the dividend decision." Explain this statement, bringing out the inter-relationship among these decisions.
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
Read from the question
- ExplainTie the answer to the quoted statement: say what it means first, 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 explained 3 marks 5 min
- 2 Inter-relationship among them 2 marks 3 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks.
Try it first. About 10 minutes for 5 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.
Under the modern approach, financial management is concerned with three major problems of a firm, corresponding to the investment, financing and dividend decisions, all taken so as to maximise shareholders' wealth.
- Investment decision. Where the firm's funds are invested, i.e. the composition of its assets: long-term assets (capital budgeting) and current assets (working capital management).
- Financing decision. How the funds are raised: the mix of debt and equity (the capital structure). Debt can raise shareholders' return but adds to their risk, so return is balanced against risk.
- Dividend decision. How much of the profit is paid out and how much retained (payout and retention ratios), depending on shareholders' preferences and the firm's investment opportunities.
- The investment decision fixes how much finance is needed; the financing decision then decides from which sources, and the cost of those funds (the cost of capital) is the rate the investments must beat.
- The dividend decision is part of the financing decision: profits retained are a source of finance, so paying more dividend means raising more from outside, and vice versa.
- The dividend decision also depends on the investment decision: a firm with profitable investment opportunities retains more.
Because each decision affects the others and all three together determine the firm's value, they must be taken jointly, with the common goal of maximising the value of the shares.
Where the 5 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The three decisions explained | 3 |
| 2 | Inter-relationship among them | 2 |
| Total | 5 |
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