Question

Define the concept of EOQ, its relevance, determine the EOQ and the time gap between two orders.

The expected cash flows of a project are as follows

ear		Cash Flows
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   300 Words

b. Future value of benefits when compounded @12 % 300 Words

Answer 1

a. NPV of the project = PV of Cash at 12% - Investment = 20000/(1+12%) + 30000/(1+12%)^2 +40000/(1+12%)^3 +50000/(1+12%)^4 +30000/(1+12%)^5 - 150000 = -30957.12
Since NPV is negative the project should be rejected because it reduces value to the firm. Here the future cash flows are all discounted from year 1 to year 5 and subtracted from the present value of investment. Higher the time period of cash flow more will be discounting factor for that particular cash flow.

NPV = PV of cash flows - Initial Investment. NPV is the best capital budgeting tool to identify a project between mutually exclusive projects and independent projects and to calculate the profitability of the investment. The discounting factor taken here is the WACC of the project which is calculated by weighted average of cost of equity, debt and preferred stock. Accuracy of NPV is dependent on prediction of future cash flows and WACC calculation. Any error in this calculation could lead to accepting of bad projects and rejecting of good projects.

NPV ignores tax savings in valuation.

NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow.
3. It is good in evaluating project involving large investment is of large scale projects.
4. Here reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects.

Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.

Assumptions:
1. The reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same

Improvement:
1. It can be improved by adding extra risk premium on WACC and estimating cash flows meticulously.

b. FV of Benefits when compounded at 12% = 20000*(1+12%)^4 + 30000*(1+12%)^3 +40000*(1+12%)^2 +50000*(1+12%)^1+30000 = 209794.23

b. FV of Benefits when compounded at 12% = 20000*(1+12%)^4 + 30000*(1+12%)^3 +40000*(1+12%)^2 +50000*(1+12%)^1+30000 = 209794.23

If FV of entire project then calculation is as follows =209794.23 -150000*(1+12%)^5=-54557.02

Future value of benefits helps in identifying the value of project at the end of the project. Here all benefits are calculated from year 1 to year 5 . Since future value of all cash flows is negative the project should be rejected. Infact it reduces the value of the firm

FV also just like NPV ignores tax savings in valuation.

FV strengths:
1. It factors in time value of money and uses cost of capital as its investment factor.
2. It factors in the risk in the cash flow as cost of capital factors in the risks.
3. Here also reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects but it is inferior to NPV

Weakness:
1. It is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2 . Future cash flows are heavily influenced by inflation which show a different result. If inflation is not factored in the calculation it will show distorted results.
3. Estimating future cash flows for capital budgeting decision might not be accurate.

Assumptions:
1. The reinvestment rate is same as cost of capital; and is reinvested at higher or lower rate.
2 It assumes that the cost of capital will remain same over all future periods but in real life the target debt equity structure keeps on changing due to change in cost of debt, cost of equity and any changes in tax structure also changes cost of capital. These changes heavily influence future value calculation

Improvements in Future value:
1. It can be improved by adding extra risk premium on capital and estimating cash flows meticulously.
2. Factoring in inflation can surely increase the accuracy of the calculations.

Please Discuss in case of Doubt

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