Question

How does finanancing policy, investment policy and dividend policy interelate ? 10 marks

Answer 1

From the point of view of financial management, there are three key policy areas any firm must focus on, These are investment policy, financing policy, and dividend policy. All the three policies must necessarily focus on the overall objective of the firm which must be wealth maximization for the shareholders.

At the very core, these policies involve allocation of limited resources to one or more of these competing decision areas. As a result, a financial manager will always to be mindful of allocating scarce resources in such a way that the wealth maximization goal is optimized.

• INVESTMENT POLICY: This is the first policy area. As part of this policy, the finance manager must ascertain resources needed to run the firm. Such resources can be broken down into two categories:

Short-term: This relates to resources needed to run the day to day operations of the firm relating mostly to working capital requirements

Long-term: This relates to resources needed to fund capital-intensive projects whose benefits will.accrue for more than one year

• FINANCING POLICY: After having ascertained how much of short-term and long-term resources are needed, as part of this policy the firm must determine the source from which the resources need to be obtained. The two main sources are equity and debt. The finance manager must make sure that cost of raising such resources is optimal so that the wealth maximization objective is furthered.

• DIVIDEND POLICY: Dividend is the amount of profit that will be distributed among the shareholders. This is seen as the return enjoyed by the shareholders for the capital they invest in the firm. Evidently, high rate of dividend means higher wealth for the shareholders.

As can be seen from the above points, these three areas are closely inter-linked. Clearly, none of these decisions can be taken in isolation, and nor are they independent of each other. For example - a company which has plans for expansion in the future will have a higher requirement of long-term funds. This will have an impact on the cost of raising such funds, which in turn will reduce the profits of the company and therefore will reduce the potential dividend pay-out.

As a result, it is imperative that any tactical or strategic decision is arrived at only after assessing the joint impact of each of the decision on the market value of the company and its shares to achieve the overall objective of the business.