Question

In a financial plan, how is the amount of borrowing determined?

A.In direct proportion to sales growth

B.By the needed increase in fixed assets

C.By the increase in total assets minus the increase in cash

D.By management's D/E decision

PLEASE explain what is D/E decision

Answer 1

All the options listed are used to finalize a financial plan while the management's Debt/Equity decision is used to determine the amount of borrowing by the business.   

The preparation of financial plan begins with preparation of the sales forecast. Once the sales levels are projected, the associated direct and indirect expenses are estimated and the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) can be computed. The next step would be to estimate the investment in fixed assets to support the growth in business or future expansion. The working capital requirement would also have to be assessed to arrive at the total funding need for the plan period. Once the borrowing needs are determined the final step would be to assess the optimal financial leverage and capital structure so as to maximize wealth. The Debt/Equity decision is one of the decisions which decide the form of borrowings i.e. whether the company should go for debt issue or borrowing from lenders/banks or whether the company should go for equity issue or borrowing from the owners/stockholders. Various factors need to be taken into account before the D/E decision can be taken. A business can increase leverage by going for debt issues or direct borrowing and decrease leverage by going for equity issue. The capital structure would determine the value of the business. One of the most important factor in financial leverage is the Weighted Average Cost of Capital(WACC). The goal would be to reduce the WACC in order to maximize the value of the firm. Financial leverage affects the EPS and ROE of the firm since debt financing results in fixed interest expenses. Higher D/E ratio is also not preferred by the stock holders since it reduces the EPS and ROE of the firm. A very low D/E ratio, on the other hand, would mean lost opportunity since the company would be seen as not availing the opportunity to avail low cost funds available in the market. Hence the decision on the optimal financial leverage is an important element of the financial plan.