UNIT 7 PLEASE ADD THIS ANSWERS IN QUESTION NUMBER 2 PAGE 18

Q2. Write a sh rt ! te ! Mi""er a!# Orr M #e" A!s$ Mi""er a!# Orr M #e" : The earlier two models assume that one of the two cash flow variables namely cash inflow or cash outflow is constant and thus come out with a solution on optimal withdrawal value or investment value. In a situation where both inflow and outflow are not constant, Miller and Orr model is useful. The model is based on controllimit approach. According to the approach, the optimum level is first derived based on certain assumptions and this optimum level needs to disturbed only when the assumptions are violated. Miller and Orr model using the interest rate on mar etable securities, transaction cost and minimum desired level of cash, derive the optimal cash holding for the firm with the use of following e!uation " # $%& b '2()%& *(+ , 1%& ' L -here " # Optimum cash holding b # the fi.ed transaction cost per transfer * # the daily yield on mar etable securities '/ ( 0ariance of daily changes in the cash balance 1 # Minimum desirable cash prescribed by the management 2sing the minimum desirable cash limit called 1ower 1imit %1(, Miller and Orr model gives the 2pper 1imit of cash holding %3(, which is e!ual to H(&)*2L As long as cash is within upper limit %3( and lower limit %1(, no action is re!uired. The moment the cash balance breached one of these two limits, an action is re!uired. If the cash balance touched the upper limit %3(, then all the e.cess cash above the optimal holding %"( is invested in mar etable securities. 4imilarly, if the cash balance touched the lower limit %1(, the firm sells mar etable securities to an e.tent that brings the cash balance bac to optimal cash holding %"(. The following e.ample shows how the three values given in the Miller and Orr model are derived. The Treasurer of 5lue 6iamond 3otel wants to develop a cash management model for investing surplus cash in mar etable securities. 4ince the cash flows show a volatile behaviour, the Treasurer feels the Miller and Orr model is the most suitable for the situation. An analysis of last three-year daily cash flows shows a standard deviation of 7s. 8/,/99. Investment in mar etable securities

currently offers a return of 8/: per annum. The transaction cost per transaction is 7s.;99. The Treasurer believes the hotel should have minimum cash balance of 7s. /9,999. -hat is the optimal cash holding< -hen an investment or disinvestment action is to be ta en< 4ubstituting the above values in the Miller and Orr model, we get the following: " # $%&.;99.8//992()%&.%.8/);=>((+ , 8); ? /9999 # &=@9/ 3 # %; . &=@9/( - %/ . /9999( # 89989@ 1 # /9999 Thus, the cash management policy is when the cash balance goes below 7s./9,999, mar etable securities are sold and cash balance is brought bac to 7s.&=@9/. If the cash balance e.ceeds 7s. 89989@, the cash value above 7s.&=@9/ is invested in mar etable securities. The cash balance is allowed to move between 7s. /9999 and 7s.89989@ and occasionally brought down to the optimum level. Most firms donAt use their cash flows uniformly and also cannot predict their daily cash inflows and outflows. Mi""e*Orr Model helps them by allowing daily cash flow variation. 2nder the model, the firm allows the cash balance to fluctuate between the upper control limit and the lower control limit, ma ing a purchase and sale of mar etable securities only when one of these limits is reached. The assumption made here is that the net cash flows are normally distributed with a Bero value of mean and a standard deviation. This model provides two control limits C the upper control limit and the lower control limit as well as a return point. -hen the firmAs cash limit fluctuates at random and touches the upper limit, the firm buys sufficient mar etable securities to come bac to a normal level of cash balance i.e. the return point. 4imilarly, when the firmAs cash flows wander and touch the lower limit, it sells sufficient mar etable securities to bring the cash balance bac to the normal level i.e. the return point.

The lower limit is set by the firm based on its desired minimum Dsafety stoc E of cash in hand The firm should also determine the following factors: 8. An interest rate for mar etable securities, %i( /. A fi.ed transaction cost for buying and selling mar etable securities, %c( ;. The standard deviation if its daily cash flows, %s( The upper control limits and return path are than calculated by the Miller-Orr Model as follows: 6istance between the upper limits and lower limits is ;". The Miller-Orr Model is more realistic as it allows variation in cash balance within the lower and upper limits. The lower limit can be set according to the firmAs li!uidity re!uirement. To determine the standard deviation of net cash flows the pasty data of the net cash flow behaviour can be used. Managerial attention is needed only if the cash balance deviates from the limits.