- 6 Marks
Question
When determining the financial objectives of a company, it is necessary to take three types of policy decisions into account: investment policy, financing policy, and dividend policy.
Required:
Discuss the nature of these three types of decisions, commenting on how they are interrelated and how they might affect the value of the firm (i.e., the present value of projected cash flows).
Answer
The investment decision considers the benefits of investing cash either in projects, working capital, or high-yield deposit accounts. It is crucial for shareholders, as it affects cash flow generation, dividends, and share price. Shareholders compare the risk versus return, knowing that higher-risk investments require higher returns.
The financing decision involves selecting the sources of finance, typically a mix of equity and long-term debt. Debt is cheaper but increases risk for shareholders due to interest obligations, potentially affecting company stability.
The dividend decision determines how much profit is distributed to shareholders versus retained for future investment. Predictable dividends tend to reduce perceived risk and increase firm value.
These three decisions are interrelated as funding investments may come from internal retained earnings or external financing. The cost of capital from the financing decision affects investment viability, which impacts dividends. Ultimately, these decisions together influence the present value of future cash flows, thus affecting the firm’s value.
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