Financial Analysis of Cartier Company - Assignment Example

? Capital Investment Decisions Capital Investment Decisions The recently introduced changes in the lending regulatoryenvironment, specifically with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, have significantly impacted banks’ ability to lend money to businesses for capital projects and acquisitions. The Dodd-Frank Act is an economic policy passed in the United States in response to the recent global recession. This Act brought tremendous changes to the American financial regulatory environment that can have a great influence on the nation’s financial services industry. The stated aim of this recently introduced legislation is “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abuse financial services practices, and for other purposes” (GPO, n. d.). Even though this Act was passed with intent to protect the nation from another financial crisis, it adversely affects banks’ ability to extend financial assistance to various business sectors. This legislation noticeably reduces banks’ lending limits. For instance, the Act strictly requires banks not to lend money to risky projects or business organizations that are less likely to repay debts. Often, it cannot be possible to accurately evaluate the potentiality of capital projects or business acquisitions because those ventures depend on a set of uncertain future events. According to the American Bankers Association (2012), this Act has limited price thresholds for certain lending segments and framed new disclosure forms and procedures for all types of mortgages. As a result, large business corporations would face potential challenges in meeting business expansion needs timely. Another disappointing feature of this Act according to the American Bankers Association (2012) is that it has mandated many stronger legal liabilities in connection with real estate finance. Although these policy changes are effective to ensure the accountability and transparency of banking transactions, business houses often find it difficult to raise adequate funds to finance capital projects and acquisitions. Consequently, entrepreneurs and other business organizations would hesitate to undertake new business development ventures; and this situation would adversely affect the growth rate of the US economy as a whole. The Forbes writer Lenzner (2012) argues that the Dodd-Frank Act is a ‘confused, bloated law’ because this policy change has failed to address many concerns including cost, efficiency, and growth. 2. No economic policy can assure 100 percent that it can prevent a financial crisis in the future. In contrast, economic policies or legislative amendments are introduced to lessen the chances of economic downturns or to reduce the impacts of a future financial crisis. The Act implies that the US economy has to make some regulatory changes in order to forecast and respond to the next crisis effectively. Hence, the Dodd-Frank Act itself says that it would not guarantee the prevention of a future financial crisis. The US policymakers hold the view that America’s largest financial firms represent some of the major huge pillars supporting the US economy. They point out that damages to these pillars during the 2008 global financial crisis worsened the economic status of the nation. It is identified that the increased governmental support persuaded these big companies to borrow cheaply and to take greater risks. In short, the “too big to fail’ status of those large financial companies can be considered as a major factor contributed to the recent recession. According to Will Melick, the Gensemer Professor of Economics (as cited in Kenyon College Alumni Bulletin (2012), the Dodd-Frank Act contains provisions for certain restrictions on financial firms’ operational activities in exchange for the protection from competition. The author adds that this regulation would assist those firms to grow even larger. Melick claims that if one of those companies goes astray, the resulting financial crisis will be more severe and can have more dreadful effects on the US economy. Melick also says that although this Act suggests mechanisms to reduce the challenges of large firm failures and to lessen their impacts on the economy, those mechanisms are not much credible (cited in Kenyon College Alumni Bulletin, 2012). As per the provisions of the Dodd-Frank Act, the newly formed Financial Stability Oversight Council is provided with the power to call for the liquidation of key companies and to demand the break of an organization that challenges the stability of the economy in the event of a severe crisis. Even though the council has such a power, it would not be willing to liquidate or break up such a huge company in the real life. As Menza (2012) reports in CNBC dated Sep 12, two bank executives told the CNBC that the Dodd-Frank Act would not actually prevent a future financial crisis. In short, it can be stated that the new Act is not potential enough to rebuild the US financial system; but it tries to improve the pre-crisis financial order. 3. Net Present Value (NPV) can be simply referred to as the difference between the current value of cash inflows and current value of cash outflows. This method is widely employed in capital budgeting process to estimate the possible returns from an investment or project. In order to evaluate the feasibility of a project, the NPV method compares current value of a currency to the value of that same currency in a particular future period by considering inflation rates and returns. A business project or investment is advisable for an investor if its NPV is positive and the investor must reject the project if it shows a negative NPV. Scholars define “internal rate of return (IRR) of an investment as the discount rate which makes the NPV exactly equal to zero” (Floyd & Allen, 2002, p.324). This method is also employed to evaluate the potentiality of a business project. Here, a project’s potentiality rises with an increase in its internal rate or return. While comparing the NPV with IRR, it seems that the NPV has a number of potential competencies over the IRR. The NPV method is simpler to use. In case of IRR, it is necessary to hunt for the discount rate that will provide a net present value of zero. The probability of errors is very high in the IRR method even though a computer spreadsheet can be used to automate this calculation to some degree. In addition, it seems that a key assumption of the IRR method is questionable. Both methods hold the assumption that cash flows generated by a project or investment during its active life period are reinvested elsewhere immediately. However, these methods do not agree on the rate of return which is achieved on that cash flow and hence they keep different assumptions. Under the NPV method, the rate of return is considered as the discounted rate whereas the IRR method assumes that rate of return is the project’s internal rate or return. In the view of Noreen, Brewer & Garrison (2011), this assumption may be questionable or unrealistic if the internal rate of return of the project is high. The assumption that the cash inflows will be reinvested at rate of return equal to the discount rate appears to be more realistic- specifically if the discount rate is the firm’s capital cost or an opportunity rate of return. For instance, if the discount rate is the firm’s capital cost, “this rate of return of return can be actually realized by paying off the company’s creditors and buying back the company’s stock with cash flows from the project” (Noreen et al, 2011, p.557). In short, the NPV method and the IRR method do not agree on the feasibility of the project. Hence, it is better to employ the NPV method because it is based on more realistic assumptions. 4. In an environment of scarce resources, tools like capital asset pricing model (CAPM) and NPV can be employed to make potential investment decisions. The CAPM is used to analyze the relationship between risk and expected rate of returns in times of pricing of securities. More clearly, this financial tool is useful to calculate an asset’s required rate of return while it is planned to invest in a business venture. In a scarce resource environment, the organization should invest its assets in a project that would yield the highest rate of return and maximize the firm’s profitability. Therefore, it is recommendable for the firm to use CAPM to estimate NPV by considering the cost of capital as the discounted rate. For this, first the organization has to determine the required rate of return from an asset using the CAPM. Second, the firm has to assess whether the project is able to yield the estimated returns using the NPV method. This strategy would assist the financial assist to identify the most potential business projects and thereby to make better use of its scarce resources. While choosing a project, the financial analyst must make sure that the project would not require further investments in the near future because such a situation may trouble the organization. In addition, the financial analyst has to give specific attention to the employees’ skills and capabilities. Market trend forecasts can have a great influence on the analyst’s decisions because productivity of a project often depends on some uncertain future events. In short, the financial analyst should make combined use of CAPM and NPV tools to choose the project that would provide the firm with highest level of competencies. References American Bankers Association. (2012). Dodd-Frank and Community Banks Your Guide to 12 Critical Issues. Retrieved from http://www.aba.com/aba/documents/DFA/DFGuide.pdf Floyd, C. F & Allen, M. T. (2002). Real Estate Principles. Dearborn Real Estate. GPO. (n. d.). Congressional Bills. Retrieved from http://www.gpo.gov/fdsys/browse/collection.action?collectionCode=BILLS Kenyon College Alumni Bulletin. (2012). Burning Question: Will the Dodd-Frank Act avert another financial crisis? Retrieved from http://bulletin.kenyon.edu/x3554.xml Lenzner, R. (2012). Too big not to fail. Forbes. Feb 18. Retrieved from http://www.forbes.com/sites/robertlenzner/2012/02/18/too-big-not-to-fail/ Menza, J. (2012). Dodd-Frank Won't Prevent Another Financial Crisis: Pros. CNBC. Sept 12. Retrieved from http://www.cnbc.com/id/49003944/Dodd_Frank_Won_t_Prevent_Another_Financial_Crisis_Pros Noreen, Brewer & Garrison. (2011). Managerial Accounting For Managers. New Delhi: Tata McGraw-Hill Education. Read More