Corporate Finance

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Corporate Finance

The company needs close to Rs 335 crore in the next seven years. Having estimated the future financ-
ing need, the management must identify the sources of finance and establish financial policies that will
ensure continuous access to capital markets on acceptable terms. The last step involves analysis of viabil-
ity of the plan, determination of debt—equity mix consistent with the company’s debt policy and stress
testing the plan. Sensitivity analysis refers to the analysis of sensitivity of profitability and other financial
variables to changes in sales. Sensitivity analysis involves observation of changes in financial forecast for
changes in underlying variables. For instance, if the growth in profit after tax for the company mentioned
in the previous example were to be only 15 percent throughout, what would happen to EFR? Financial
ratios?
The steps involved in forecasting and planning is summarized in the following diagram:

Management Goals

Outlook for Sales

Investment

Requirement

External

Financing Need

Formulation of

Strategy

Financial Statements and Asset Pricing

The value of a company’s equity is a function of cost of equity which in turn depends on beta. As pointed
out in chapter 5, some studies in America have reported theoretical links between financial leverage and
beta and variance of security returns. The higher the financial leverage, the higher is the beta. Likewise few
other studies have shown that the higher the operating leverage (ratio of fixed to variable costs), the higher
the beta. Other factors like debt: equity ratio, preferred stock to equity ratio, sales to equity ratio, current
ratio, standard deviation of earnings to price ratio also seem to be highly correlated with estimates of beta
derived from security returns. Stock markets price a company’s securities on the basis of financial inform-
ation released to the market. A manager would be interested in knowing, for instance, how stock markets
react to earnings announcements. Does the release of financial information have any influence on trading
volume and so on? Studies in America suggest that:

• The release of interim and annual earnings is associated with both increased trading volume and increased
  return variability.