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MB0045 : a) Discuss the advantages of ordering Economic order quantity of inventory. b) Discuss the Dividend discount model of measuring cost of equity.

Posted on: October 18, 2011

MB0045 : a) Discuss the advantages of ordering Economic order quantity of inventory.
b) Discuss the Dividend discount model of measuring cost of equity.

Answer :  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.

Advantages of ordering Economic order quantity of inventory.

  • 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.

Dividend discount model of measuring cost of equity

The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.In other words, it is used to evaluate stocks based on the net present value of the future dividends.

Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as

whereP0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.

This equation is also used to estimate cost of capital by solving for r

From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; rg cannot be negative, i.e., r>g. In the short run if g>r, then usually a two stage DDM is used:

Therefore,

whereg denotes the short-run expected growth rate, denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.

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