2.

The finance department of Parshwanath Corporation gathered following information-

The carrying cost per unit of inventory is Rs10
The cost per order is Rs20
The number of units required is 50000 per year
The variable cost per unit ordered is Rs5
The purchase price per unit is Rs50
Define the concept of EOQ, its relevance, determine the EOQ and the time gap between two
orders.

Answer: EOQ
Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering
and carrying costs for an item of inventory based on its expected usage. EOQ model answers the
following key quantum of inventory management.
● What should be the quantity ordered for each replenishment of stock?
● How many orders are to be placed in a year to ensure effective inventory management?
EOQ is defined as the order quantity that minimises the total cost associated with inventory
management.

Assumptions of EOQ model

● Constant or uniform demand: The demand or usage is even through-out the period
● Known demand or usage: Demand or usage for a given period is known i.e. deterministic
● Constant unit price: Per unit price of material does not change and is constant irrespective
of the order size
● Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of
inventory
● Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero.
Constantly there is no shortage of inventory. Economic order quantity is represented using the
following formula:

EOQ = √2DS/H

Where,
D = Annual demand
S = Cost per order
H = Holding cost

Calculation:
EOQ = √2*50000*20/10

= √2000000/10

= √200000

= 448 units.

Total orders per year = Annual demand/Quantity

= 50000/448
= 112 approximately

Time between orders = No. of working days per year / number of orders

= 365/112

= 3.26 days

3. The expected cash flows of a project are as follows

YEAR CASH FLOW
0 -150000
1 20000
2 30000
3 40000
4 50000
5 30000
The cost of capital is 12% Discuss and Calculate
a. NPV for the project
b. Future value of benefits when compounded @12 %

Answer: a) The net present value (NPV) method is the classic economic method of evaluating the
investment proposals. It is a DCF technique that explicitly recognizes the time value of money. It
correctly postulates that cash flows arising at different time periods differ in value and are
comparable only when their equivalents—present values—are found out. The following steps are
involved in the calculation of NPV:
• Cash flows of the investment project should be forecasted based on realistic assumptions.
• Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the project’s opportunity cost of capital, which is equal to the
required rate of return expected by investors on investments of equivalent risk.
• Present value of cash flows should be calculated using the opportunity cost of capital as the
discount rate.
• Net present value should be found out by subtracting present value of cash outflows from
present value of cash inflows. The project should be accepted if NPV is positive (i.e., NPV >
0).

Acceptance Rule
It should be clear that the acceptance rule using the NPV method is to accept the investment project
if its net present value is positive (NPV > 0) and to reject it if the net present value is negative (NPV
< 0). Positive NPV contributes to the net wealth of the shareholders, which should result in the
increased price of a firm’s share. The positive net present value will result only if the project
generates cash inflows at a rate higher than the opportunity cost of capital. A project with zero NPV
(NPV = 0) may be accepted. A zero NPV implies that project generates cash flows at a rate just equal
to the opportunity cost of capital. The NPV acceptance rules are:
• Accept the project when NPV is positive NPV > 0
• Reject the project when NPV is negative NPV < 0
• May accept the project when NPV is zero NPV = 0
The NPV method can be used to select between mutually exclusive projects; the one with the higher
NPV should be selected. Using the NPV method, projects would be ranked in order of net present
values; that is, first rank will be given to the project with highest positive net present value and so on.

Calculation of Net present value of the project

YEAR CASH FLOW PV VALUES @12% PRESENT VALUE
0 -150000 1 -150000
1 20000 0.8929 17858
2 30000 0.7972 23916
3 40000 0.7118 28472
4 50000 0.6355 31775
5 30000 0.5674 17022
NPV -30957

Net Present Value of the project if the cost of capital is 12% is loss of Rs. 30957. Therefore the
project should not be accepted.

b) Future value of benefits when compounded @12 %

The value at the end of 5 years, compounded annually at a rate of interest of 12% per annum, is
calculated as follows:
NUMBER OF COMPOUNDED
YEA CASH YEARS INTEREST FUTURE
R FLOW COMPOUNDED FACTOR @12% VALUE
1 20000 4 1.574 31480
2 30000 3 1.405 42150
3 40000 2 1.254 50160
4 50000 1 1.12 56000
5 30000 0 1 30000
NPV 209790

The value at the end of the fifth year is Rs. 209790