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103

Figure 8.1 The Miller-Orr Model

Cash balance
Invest this amount
Upper limit
Return point

Lower limit
Time
Replenish this amount of cash
the transaction cost. Rather than hiring an external broker, an organization
could choose to manage its cash internally by using its own personnel, and
then the transaction cost is the cost associated with the hire and use of
these people. Daily interest rate (I) is the daily rate of return on an investment. In public organizations, where safety is a major concern for investment, the interest rate for U.S. treasury bills, one of the safest investment
choices, can be used.
The variance of daily net cash flow (V) is used to measure the fluctuation
of cash balance. A larger value of V indicates that a cash flow fluctuates
more. It can be calculated by using daily net cash flow (Daily Deposits
Daily Withdrawals) for a selected number of days (e.g., 100 days), and by
computing the variance of the cash flow for these days. It is important to note
that the selection of these days should reflect the true fluctuation of cash
flows for an organization at a given time (e.g., a year). If the organization has
different patterns of cash flows in different seasons of a year, then the days
selected should include days in different seasons. Let us first look at a simple
example to illustrate what the variance is, and then use Excel in the calculation. Let us say that, during the past five days, we have a series of net cash
flows of $10.00 in Day 1, $20.00 in Day 2, $5.00 in Day 3, $7.00 in Day 4,
and $10.00 in Day 5. The five-day average is ($10.00 + $20.00 $5.00 +
$7.00 $10.00)/5 = $4.40. Table 8.4 includes the statistics needed to compute the variance.
The total of the difference squared is 31.36 + 243.36 + 88.36 + 6.76 +
207.36 = $577.20. Variance is $577.20/4 = $144.30, where 4 is the number

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TOOLS FOR FINANCIAL IMPLEMENTATION

Table 8.4
An Example of Computing Variance of Daily Net Cash Flow

Day
1
2
3
4
5

Net cash
flow ($)
(1)

Average
(2)

Difference
(3) = (1) (2)

Difference
squared
Square of (3)

10.00
20.00
5.00
7.00
10.00

4.40
4.40
4.40
4.40
4.40

5.60
15.60
9.40
2.60
10.44

31.36
243.36
88.36
6.76
207.36

of days minus 1 (5 1). Statisticians use the following formula to compute

the variance.
n

V =

(X

)2

i =1

(n 1)

Xi represents individual cases (like $10.00, $20.00, . . ., in the example),

where i is the representation of the individual case number. For example,
X1 is individual Case 1; X2 is individual Case 2. is the average. In our
example, it is $4.40. So (Xi ) is the difference between an individual
case and the average. is the summation sign used to calculate the sum of
(Xi )2, which is $577.20 in this example. Finally, n is the number of
cases. The variance can be easily calculated from Excels Data Analysis
Function.
Step 1:
Step 2:
Step 3:
Step 4:

Enter the data in an Excel file.

Go to Data Analysis under the Tool function.
Select Descriptive Statistics from the Data Analysis window.
Select the data for the Input Range of the Descriptive Statistics window.
Step 5: Select an Output Range cell located differently from the Input Range.
Step 6: Click Summary Statistics and OK and you will see results
shown in Excel Screen 8.1.
Use the data in Table 8.4 to practice the Excel Data Analysis. You should
be able to determine the variance shown in Screen 8.1. To make cash balance
decisions, you also need the return point, which is the cash balance point
that indicates the amount of the transfer.

CASH MANAGEMENT

105

Excel Screen 8.1 Calculating Variance of Net Cash Flow

Return Point = Lower Limit + (Spread/3).

The decision rules in the Miller-Orr model are: (1) No transaction is needed
if the cash balance falls between the lower limit and the upper limit. (2) If the
cash balance rises to the upper limit, invest cash by the amount of Upper
Limit Return Point. (3) If the cash balance falls to the lower limit, sell
investments by the amount of Return Point Lower Limit to replenish cash.
(Review Figure 8.1 to visualize this decision-making process.)
Let us look at an example. Suppose that an agency has a minimum cash
balance of $20,000 (lower limit) required by its bank. Suppose that the variance of daily net cash flows is $6,250,000, a daily interest rate is 0.025 percent, and the transaction cost is $20. So, the spread = 3 (0.75 20 6,250,000/
0.00025)1/3 = $21,600. Lower limit = $20,000. Upper limit = $20,000 + $21,600
= $41,600. Return point = $20,000 + ($21,600/3) = $27,200.
Thus, the agency does not need to do anything if its cash balance fluctuates
between $20,000 and $41,600. Nevertheless, if the cash balance rises to $41,600,
it should invest the cash in the amount of $41,600 $27,200 = $14,400; if the