The first and perhaps the most important decision that any firm has to make is to define the business or businesses that it wants to be. This is referred to as strategic planning and it has a significant bearing on how capital is allocated in the firm.
As strategic planning calls for evaluating costs and benefits spread out over time, it is essentially a financial decision-making process.
Once the managers choose the business or businesses they want to be in, they have to develop a plan to invest in buildings, machinery, equipment, research and development, godowns, showrooms, distribution networks, information infrastructure, brands, and other long-lived assets. This is the capital budgeting process.
Once a firm has decided on the investment projects it wants to undertake, it has to figure out ways and means of financing them. The key issues in capital structure decisions are: What is the optimal debt-equity ratio for the firm?
Which specific instruments of equity and debt finance should the firm employ/which capital market should the firm access? When should the firm raise the finances? At what price should the firm offer its securities? An allied issue is the distribution policy of the firm.
What is the optimal dividend payout ratio for the firm? Should the firm buy back its own shares? Capital structure and dividend decisions should be guided by considerations of cost and flexibility, at the main.
The objective should be to minimize the cost of financing without impairing the ability of the firm to raise finances for value-creating investment projects.
Working Capital Management
WCM, also referred to as short-term financial management, refers to the day-to-day financial activities that deal with current assets and current liabilities. The key issues in WCM are: What is the optimal level of inventory for the operations of the firm?
Should the firm grant credit to its customers and, if so, on what terms? How much cash should the firm carry on hand? Where should the firm invest its temporary cash surpluses? What sources of short-term finance are appropriate for the firm?