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BALANCE
Baumol Model
Assumptions of the model:
1. Net cash flow is the same everyday
2. Net cash flow is known with certainty
Baumol Model
Golden Peak Corp. began week 0 with a cash balance (C) of P1.2
million. Each week, outflows exceed inflows by P600,000. The
cash balance drops to zero at the end of week 2.
Average cash balance = (Beginning balance + Ending balance)
over the 2-week period
2
= (P1,200,000 + P0)
2
= P600,000
Baumol Model
Baumol Model
If C were set higher, say P2.4 million, cash would last
4 weeks before the firm would have to sell
marketable securities, but the firms average cash
balance would increase to P1.2 million (from
P600,000).
If C were set at P600,000, cash would run out in 1
week, and the firm would have to replenish cash
more frequently, but the average cash balance would
fall from P600,000 to P300,000.
Baumol Model
To determine the optimal strategy, the firm needs to
know the following:
F = the fixed cost of selling securities to
raise cash (trading or transaction cost)
T = the total amount of cash needed over the
relevant planning period (for ex., one year)
K = the opportunity cost of holding cash (interest
rate)
Baumol Model
Opportunity costs (interest forgone):
= Average Cash Balance x Interest Rate
= (C/2) x K
Trading costs:
= No. of times the firm sells marketable securities x Fixed
Cost of trading
= (T/C) x F
Baumol Model
Assuming Golden Peak Corporations opportunity cost is 10%
and incurs $1,000 each time it sells its marketable securities.
Weekly cash requirement is $600,000; therefore total cash
needed in a year is $600,000 x 52 weeks or $31,200,000.
Baumol Model
Total Costs = Opportunity costs + Trading costs
= [(C/2) x K] + [(T/C) x F]
Using the numbers generated earlier, we have:
Notice that total costs start out at P246,500 and declines to about P82,000 before starting to
rise again.
So what is the optimal cash balance (ECONOMIC CONVERSION QUANTITY or ECQ)?
C
T
K = F
2
C
Multiply both sides by C
T F
C =2
K
C
K =T F
2
2TF
C =
K
*
C
K
Opportunity Costs
2
Trading costs T F
C*
Size of cash balance
The optimal cash balance is found where the opportunity
costs equals the trading costs
C* =
2T
F
K
The total cost at the ECQ level is P78,994, and it does appear to
increase as we move in either direction.
as with the Baumol model, the optimal cash balance (Z) depends on
trading costs and opportunity costs.
the only extra data needed is 2, the variance of the net cash flow per
period. The period can be a day, a week, a year, for example, as long as
the interest rate and the variance are based on the same length of time.
H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z
to raise cash to get
us up to the target
cash balance.
L
Time
H = 3Z 2L
3
F
Z* = 3
L
4K
where s2 is the variance of net daily cash flows.
The average cash balance in the Miller-Orr model
is
4Z * L
Average cash balance =
3
2
securities.
Exercises
Baumol Model
Your firm utilizes P165,000 a week to pay bills. The standard deviation of these
cash flows is P20,000. The fixed cost of transferring funds is P48 a transfer. The
applicable interest rate is 6%. The firm has established a lower cash balance limit
of P100,000. Answer these five questions using the Baumol model:
What is the optimal cash balance?
What is the optimal average cash balance?
What is the opportunity cost of holding cash?
What is the trading cost of holding cash?
What is the total cost of holding cash?
Baumol Model
Your firm utilizes P165,000 a week to pay bills. The standard deviation of these
cash flows is P20,000. The fixed cost of transferring funds is P48 a transfer. The
interest rate is 6% per annum. The firm has established a lower cash balance limit
of P100,000. Answer the following using the Baumol model:
What is the optimal cash balance? (P117,167)
What is the optimal average cash balance? (P58,584)
What is the opportunity cost of holding cash? (P3,515)
What is the trading cost of holding cash? (P3,515)
What is the total cost of holding cash? (P7,030)
Baumol Model
What is the optimal initial cash balance?
C* =
=
( 2T F)
R
2 $165,000 52 $48
.06
$823,680,000
=
.06
= $117,166.55
= $117,167
Miller-Orr model
Your firm utilizes P130,000 a week to pay bills. The standard deviation of these
cash flows is P15,000. The fixed cost of transferring funds is P51 a transfer. Your
firm has established a lower cash balance limit of P80,000. The weekly interest
rate is .067%. Use the Miller-Orr model to answer these three questions.
Miller-Orr model
What is the optimal initial cash balance?
3
s
C* = L F
R
4
1/ 3
3
$15,000
= $80,000 $51
.00067
4
= $80,000 $23,417.26
= $103,417.26
= $103,417
.33333
Miller-Orr model
What is the optimum upper limit?
U* = (3 C*) (2 L)
= (3 $103,417) (2 $80,000)
= $310,251 $160,000
= $150,251
Miller-Orr model
What is the average cash balance?
(4 C*) - L
Average cash balance =
3
(4 $103,417) $80,000
=
3
= $111,222.67
= $111,223