The three types of policy decision for determining the financial objectives of a company are investment policy, financing policy and dividend policy.
Investment policy is concerned with the types of capital investment that a company makes in order to develop its business (such as replacement of non-current assets, new investment projects concerned with generating organic business growth, and acquisitions of other businesses). Investment policy will stipulate the types of investment that are targets and any restrictions over investment choices.
From a financial point of view, the company’s investments will normally need to earn a sufficient return to cover the cost of funds used to finance them. A successful investment will earn a surplus over this minimum required rate of return, which will therefore increase the value of the firm by increasing the present value of its projected cash flows. The minimum required rate of return of an investment project is dependent on its systematic risk (that is the part of its risk that depends on general market factors). The higher the systematic risk, the higher the minimum required return for the investment.
There will be exceptions to this general rule. Investment policy may stipulate types of investment that do not have to cover their cost of funding because they generate other benefits to the company or to other stakeholders.
Financing is concerned with the sources of funds used to finance capital investments and working capital. The general principle is that funds should be obtained at the cheapest possible cost of capital (so that the present value of the firm’s cash flows is maximized), but again this is dependent on the risk the company suffers when it uses the funds.
In terms of the cost of finance, the riskier a source of funds is to the providers of finance, the more expensive its cost of capital will be. Thus, equity funds are more expensive than debt. If there is a cash crisis, interest has to be paid, but dividends do not. Unsecured debt is more expensive than secured debt, and so on.
Concerning the target and limits, financing policy will normally place targets and limits on the different types of funds used by the company: the ratio of debt to equity (gearing), the amount of floating rate debt, the proportion of short term to long term debt and so on. These ratios will also be affected by the needs of lenders, who may stipulate maximum gearing levels or minimum liquidity ratios. Financing policy will also consider the extent to which foreign currency finance is used, as well as hedging instruments to reduce currency and interest rate risk.
Dividend policy is concerned with the pattern of dividend payments to shareholders. This implies more than the principle that the present value of dividends should be maximized – it is concerned with practical matters.
In case of the retention policy, a key issue is whether the dividends paid should be a high proportion of equity earnings that will result in the company needing to seek external finance more often) or a low proportion of earnings (which will leave more funds available for reinvestment). Although in a perfect market these decisions would result in identical present values for the firm, the existence of taxation can cause groups of shareholders to favor differing dividend policies, and the company’s dividend policy must attempt to find an appropriate balance
Regarding the pattern of dividend payment, the company must also decide whether dividends should be paid in a smooth trend (for example, 6% growth per year) or allowed to fluctuate as much as equity earnings. Again, although in a perfect market this would not be important, in practice the lack of perfect information to shareholders makes the ‘signaling content’ of dividends more significant.
The policies are related
Investment, financing and dividend policies are all inter-related. Investments must earn sufficient to cover the cost of funds used. The risk of these investments will influence the cost of these funds. Planning of investment and finance must go hand in hand, otherwise the ability to start an investment may be delayed by lack of available funds.
Cash surpluses generated by investments are equity funds, and dividend policy determines how much of these surpluses are available for reinvestment and how much are to be paid as immediate rewards to the fund providers.