Finance Function | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

The functions of finance can be categorized into three main decisions that firms must undertake: the investment decision, the financing decision, and the dividend decision. Each of these decisions should be aligned with the firm's objective of achieving an optimal balance, ultimately maximizing shareholder value. Given their interdependence, it's crucial to evaluate their collective effect on the market price of the firm's stock.

Investment Decision

The investment decision stands out as the most pivotal among the three decisions. It pertains to selecting assets in which the firm will invest its funds. These assets fall into two broad categories:

• Long-term assets, which generate returns over an extended period.
• Short-term or current assets, which can be converted into cash within a year as part of normal business operations.

Consequently, the asset selection decision can be categorized into two types. The first, concerning long-term assets, is commonly known as capital budgeting. The second, relating to short-term assets, is referred to as liquidity decision.

• Capital budgeting decision: This decision, paramount for any firm, involves selecting investment proposals expected to yield future benefits over the project's lifetime. The decision-making process includes choosing the best investment among available alternatives based on their relative benefits and returns. Evaluating the worth of investment proposals is crucial, requiring an analysis of risk and uncertainty associated with future benefits. Risk assessment involves considering uncertainties surrounding future benefits, while return evaluation involves comparing returns against a set standard, typically the company's cost of capital.
• Liquidity decision: This decision revolves around managing current assets, a fundamental requirement for long-term business success. The primary objective of current assets management is striking a balance between profitability and liquidity, which often conflict. Inadequate working capital can lead to liquidity issues and potential bankruptcy, while excessive current assets can hamper profitability. Achieving a balance between profitability and liquidity is crucial, alongside optimal allocation of funds to individual current assets to prevent shortages or excessive tying up of funds.

Financing Decision

• The financing decision, the second major decision for firms, involves determining the optimal financing mix.
• Once the asset mix is determined, the financial manager must decide how to raise funds to meet the firm's investment needs. The primary concern in this decision is determining the proportion of equity and debt capital. Since the use of debt capital affects shareholder returns and risk, the financial manager aims to achieve an optimal capital structure that maximizes shareholder returns while minimizing risk. This decision encompasses two interrelated aspects: capital structure theory and capital structure decision-making.

Dividend Decision

• The third critical decision for a firm is its dividend policy. The financial manager is tasked with determining whether profits should be entirely distributed, retained within the firm, or a combination of both. This decision should be made considering its impact on shareholder wealth. 
• The optimal dividend policy maximizes the market value of the company's shares. Consequently, if shareholders demonstrate preferences regarding the firm's dividend policy, the financial manager must establish the optimal dividend-payout ratio. Another significant aspect of the dividend decision involves identifying the factors that shape the firm's dividend policy in practice.

Conclusion

Financial management encompasses resolving the three key decisions of the firm according to the modern approach. In contrast to the traditional approach, which had a narrow focus, lacked an integrated conceptual and analytical framework, the modern approach has expanded the scope of financial management. This expansion ensures that optimal decisions are made, aligning with the objectives of the business firm.