CHAPTER FOUR
BUSINESS FINANCE
Meaning of Business Finance
Money required for carrying out business activities is called business finance. Almost all business activities require
some finance. Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it. It is
required for buying a variety of assets, which may be tangible like machinery, factories, buildings, offices; or
intangible such as trademarks, patents, technical expertise, etc. Also, finance is central to running the day-to-day
operations of business, like buying material, paying bills, salaries, collecting cash from customers, etc. needed at
every stage in the life of a business entity.
Availability of adequate finance is, prominent examples of the aspects being affected could be as under:
(i) The size and the composition of fixed assets of the business: For example, a capital budgeting decision to invest a
sum of Kshs. 1000000 in fixed assets would raise the size of fixed assets block by this amount.
( ii) The quantum of current assets and its break-up into cash, inventory and receivables: With an increase in the
investment in fixed assets, there is a commensurate increase in the working capital requirement. The quantum of
current assets is also influenced by financial management decisions. In addition, decisions about credit and
inventory management affect the amount of
debtors and inventory which in turn affect the total current assets as well as their composition.
( iii) The amount of long-term and short- term funds to be used:
Financial management, among others, involves decision about the proportion of long-term and short-term funds. An
organization wanting to have more liquid assets would raise relatively more amount on a long-term basis. There is a
choice between liquidity and profitability. The underlying assumption here is that current liabilities cost less than
long term liabilities.
( iv) Break-up of long-term financing into debt, equity etc: Of the total long term finance, the proportions to be
raised by way of debt and/or equity is also a financial management decision. The amounts of debt, equity share
capital, preference share capital are affected by the financing decision, which is a part of financing management.
( v) All items in the Profit and Loss Account, e.g., Interest, Expense, Depreciation, etc. : Higher amount of debt
means higher interest expense in future. Similarly, use of higher equity may entail higher payment of dividends.
Similarly, an expansion of business which is a result of capital budgeting decision is likely to affect virtually all
items in the profit and loss account of the business. It can, thus, be stated that the financial statements of a business
are largely determined by financial management decisions taken earlier.
Similarly, the future financial statements would depend upon past as well as current financial decisions.
Objectives
The primary aim of financial management is to maximize shareholders’ wealth, which is referred to as the wealth-
maximization concept. The market price of a company’s shares is linked to the three basic financial decisions which
you will study a little later. This is because a company funds belong to the shareholders and the manner in which
they are invested and the return earned by them determines their market value and price. It means maximization of
the market value of equity shares. The market price of equity share increases, if the benefit from a decision exceeds
the cost involved. All financial decisions aim at ensuring that each decision is efficient and adds some value. Such
value additions tend to increase the market price of shares. Therefore, those financial decisions are taken which will
ultimately prove gainful from the point of view of the shareholders. The shareholders gain if the value of shares in
the market increases. Those decisions which result in decline in the share price are poor financial decisions. Thus,
we can say, the objective of financial management is to maximize the current price of equity shares of the company
or to maximize the wealth of owners of the company, that is, the shareholders.
Therefore, when a decision is taken about investment in a new machine, the aim of financial management is to
ensure that benefits from the investment exceed the cost so that some value addition takes place. Similarly, when
finance is procured, the aim is to reduce the cost so that the value addition is even higher.
Financial Decisions
Financial management is concerned with the solution of three major issues relating to the financial operations of a
firm corresponding to the three questions of investment, financing
and dividend decision. In a financial context, it means the selection of best financing alternative or best investment
alternative. The finance function, therefore, is concerned with three broad decisions which are explained below:
Investment Decision
COMMERCE II CHAPTER 4 BUSINESS FINANCE NOTES PREPARED BY MR. ANTONY AMBIA Page 1
, A firm’s resources are scarce in comparison to the uses to which they can be put. A firm, therefore, has to choose
where to invest these resources, so that they are able to earn the highest possible return for their investors. The
investment decision, therefore, relates to how the firm’s funds are invested in different assets. Investment decision
can be long term or short-term.
Factors affecting Capital
Budgeting decision
Financing decisions
Dividend decisions
Budgeting Decision
A number of projects are often available to a business to invest in. But each project has to be evaluated carefully
and, depending upon the returns, a particular project is either selected or rejected. If there is only one project, its
viability in terms of the rate of return, viz., investment and its comparability with the industry’s average is seen.
Financing Decision
This decision is about the quantum of finance to be raised from various long-term sources. Short-term sources are
studied under the ‘working capital management’.
It involves identification of various available sources. The main sources of funds for a firm are shareholders’ funds
and borrowed funds. The shareholders’ funds refer to the equity capital and the retained earnings.
Borrowed funds refer to the finance raised through debentures or other forms of debt. The risk of default on payment
is known as financial risk which has to be considered by a firm likely to have insufficient shareholders to make these
fixed payments. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or
the repayment of capital.
Factors Affecting Financing Decisions
The financing decisions are affected by various factors. Important among them are as follows:
(a) Cost: The cost of raising funds through different sources are different. A prudent financial
manager would normally opt for a source which is the cheapest.
(b) Risk: The risk associated with each of the sources is different.
(c) Floatation Costs: Higher the floatation cost, less attractive the source.
(d) Cash Flow Position of the Company:
A stronger cash flow position may make debt financing more viable than funding through equity.
(e) Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium,
Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed
operating cost is less, more of debt financing may be preferred.
(f) Control Considerations: Issues of more equity may lead to dilution of management’s control over the business.
Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.
(g) State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the
period when stock market is rising, more people invest in equity.
However, depressed capital market may make issue of equity shares difficult for any company.
Dividend Decision
The third important decision that every financial manager has to take relates to the distribution of dividend.
Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of
the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be
retained in the business. While the dividend constitutes the current income re-investment as retained earning
Factors Affecting Dividend Decision
How much of the profits earned by a company will be distributed as profit and how much will be retained in the
business is affected by many factors.
Some of the important factors are discussed as follows:
(a) Amount of Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major
determinant of the decision about dividend.
(b) Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to
declare higher dividends.
As against this, a company having unstable earnings is likely to pay smaller dividend.
COMMERCE II CHAPTER 4 BUSINESS FINANCE NOTES PREPARED BY MR. ANTONY AMBIA Page 2
BUSINESS FINANCE
Meaning of Business Finance
Money required for carrying out business activities is called business finance. Almost all business activities require
some finance. Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it. It is
required for buying a variety of assets, which may be tangible like machinery, factories, buildings, offices; or
intangible such as trademarks, patents, technical expertise, etc. Also, finance is central to running the day-to-day
operations of business, like buying material, paying bills, salaries, collecting cash from customers, etc. needed at
every stage in the life of a business entity.
Availability of adequate finance is, prominent examples of the aspects being affected could be as under:
(i) The size and the composition of fixed assets of the business: For example, a capital budgeting decision to invest a
sum of Kshs. 1000000 in fixed assets would raise the size of fixed assets block by this amount.
( ii) The quantum of current assets and its break-up into cash, inventory and receivables: With an increase in the
investment in fixed assets, there is a commensurate increase in the working capital requirement. The quantum of
current assets is also influenced by financial management decisions. In addition, decisions about credit and
inventory management affect the amount of
debtors and inventory which in turn affect the total current assets as well as their composition.
( iii) The amount of long-term and short- term funds to be used:
Financial management, among others, involves decision about the proportion of long-term and short-term funds. An
organization wanting to have more liquid assets would raise relatively more amount on a long-term basis. There is a
choice between liquidity and profitability. The underlying assumption here is that current liabilities cost less than
long term liabilities.
( iv) Break-up of long-term financing into debt, equity etc: Of the total long term finance, the proportions to be
raised by way of debt and/or equity is also a financial management decision. The amounts of debt, equity share
capital, preference share capital are affected by the financing decision, which is a part of financing management.
( v) All items in the Profit and Loss Account, e.g., Interest, Expense, Depreciation, etc. : Higher amount of debt
means higher interest expense in future. Similarly, use of higher equity may entail higher payment of dividends.
Similarly, an expansion of business which is a result of capital budgeting decision is likely to affect virtually all
items in the profit and loss account of the business. It can, thus, be stated that the financial statements of a business
are largely determined by financial management decisions taken earlier.
Similarly, the future financial statements would depend upon past as well as current financial decisions.
Objectives
The primary aim of financial management is to maximize shareholders’ wealth, which is referred to as the wealth-
maximization concept. The market price of a company’s shares is linked to the three basic financial decisions which
you will study a little later. This is because a company funds belong to the shareholders and the manner in which
they are invested and the return earned by them determines their market value and price. It means maximization of
the market value of equity shares. The market price of equity share increases, if the benefit from a decision exceeds
the cost involved. All financial decisions aim at ensuring that each decision is efficient and adds some value. Such
value additions tend to increase the market price of shares. Therefore, those financial decisions are taken which will
ultimately prove gainful from the point of view of the shareholders. The shareholders gain if the value of shares in
the market increases. Those decisions which result in decline in the share price are poor financial decisions. Thus,
we can say, the objective of financial management is to maximize the current price of equity shares of the company
or to maximize the wealth of owners of the company, that is, the shareholders.
Therefore, when a decision is taken about investment in a new machine, the aim of financial management is to
ensure that benefits from the investment exceed the cost so that some value addition takes place. Similarly, when
finance is procured, the aim is to reduce the cost so that the value addition is even higher.
Financial Decisions
Financial management is concerned with the solution of three major issues relating to the financial operations of a
firm corresponding to the three questions of investment, financing
and dividend decision. In a financial context, it means the selection of best financing alternative or best investment
alternative. The finance function, therefore, is concerned with three broad decisions which are explained below:
Investment Decision
COMMERCE II CHAPTER 4 BUSINESS FINANCE NOTES PREPARED BY MR. ANTONY AMBIA Page 1
, A firm’s resources are scarce in comparison to the uses to which they can be put. A firm, therefore, has to choose
where to invest these resources, so that they are able to earn the highest possible return for their investors. The
investment decision, therefore, relates to how the firm’s funds are invested in different assets. Investment decision
can be long term or short-term.
Factors affecting Capital
Budgeting decision
Financing decisions
Dividend decisions
Budgeting Decision
A number of projects are often available to a business to invest in. But each project has to be evaluated carefully
and, depending upon the returns, a particular project is either selected or rejected. If there is only one project, its
viability in terms of the rate of return, viz., investment and its comparability with the industry’s average is seen.
Financing Decision
This decision is about the quantum of finance to be raised from various long-term sources. Short-term sources are
studied under the ‘working capital management’.
It involves identification of various available sources. The main sources of funds for a firm are shareholders’ funds
and borrowed funds. The shareholders’ funds refer to the equity capital and the retained earnings.
Borrowed funds refer to the finance raised through debentures or other forms of debt. The risk of default on payment
is known as financial risk which has to be considered by a firm likely to have insufficient shareholders to make these
fixed payments. Shareholders’ funds, on the other hand, involve no commitment regarding the payment of returns or
the repayment of capital.
Factors Affecting Financing Decisions
The financing decisions are affected by various factors. Important among them are as follows:
(a) Cost: The cost of raising funds through different sources are different. A prudent financial
manager would normally opt for a source which is the cheapest.
(b) Risk: The risk associated with each of the sources is different.
(c) Floatation Costs: Higher the floatation cost, less attractive the source.
(d) Cash Flow Position of the Company:
A stronger cash flow position may make debt financing more viable than funding through equity.
(e) Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium,
Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed
operating cost is less, more of debt financing may be preferred.
(f) Control Considerations: Issues of more equity may lead to dilution of management’s control over the business.
Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.
(g) State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the
period when stock market is rising, more people invest in equity.
However, depressed capital market may make issue of equity shares difficult for any company.
Dividend Decision
The third important decision that every financial manager has to take relates to the distribution of dividend.
Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of
the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be
retained in the business. While the dividend constitutes the current income re-investment as retained earning
Factors Affecting Dividend Decision
How much of the profits earned by a company will be distributed as profit and how much will be retained in the
business is affected by many factors.
Some of the important factors are discussed as follows:
(a) Amount of Earnings: Dividends are paid out of current and past earning. Therefore, earnings is a major
determinant of the decision about dividend.
(b) Stability Earnings: Other things remaining the same, a company having stable earning is in a better position to
declare higher dividends.
As against this, a company having unstable earnings is likely to pay smaller dividend.
COMMERCE II CHAPTER 4 BUSINESS FINANCE NOTES PREPARED BY MR. ANTONY AMBIA Page 2
