The Baumol cash management model PDF

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The Baumol cash management model Baumol noted that cash balances are very similar to inventory levels, and developed a model based on the economic order quantity(EOQ).Assumptions:     

possible to be forecast and fixed for the entire period, the demand for cash, constant and predictable inflow of cash, fixed interest rate throughout the period when investing in securities, rhythmic cash receipts, instant cash transfers,

The formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at one time: C=underr ootof2∗T∗F/R Wher e: Copt i mal cashl ev el Tdemandf orcas hov ert heent i r eper i odconsi der ed( y ear ) Ffix edcost sofcas ht r ansf er Ral t er nat i vecostofmai nt ai ni ngcash. Thi sf or mul acomesf r om t hef actt hati ft hel ev el ofcashi st obeopt i mal ,t hent hef ol l owi ng equal i t ymustex i st :KA=KT,t heal t er nat i v ecostmustequal t het r ansact i oncost s.These, i nt ur n,ar ecal cul at edasf ol l ows : KA=C∗R/2 KT=T*F/C

The model suggests that when interest rates are high, the cash balance held in non-interestbearing current accounts should be low. However its weakness is the unrealistic nature of the assumptions on which it is based.

Example using the Baumol model A company generates $10,000 per month excess cash, which it intends to invest in short-term securities. The interest rate it can expect to earn on its investment is 5% pa. The transaction costs associated with each separate investment of funds is constant at $50.

Required: (a)What is the optimum amount of cash to be invested in each transaction? (b)How many transactions will arise each year? (c)What is the cost of making those transactions pa?

(d)What is the opportunity cost of holding cash pa? Solution:

Restrictions on Baumola Model Although the Baumola model is a classic model of cash management, it is difficult to apply it in everyday life. The main limitation is that the company has to use up the stock evenly in order for the model to work. In practice, this is almost impossible. Also, the difficulty is that in the enterprise it is difficult to determine the precise demand for financial resources, also the expenses incurred by the company do not spread equally over the entire period. Another limitation in the application of the model is also a time-varying transaction commission, which can often be negotiated and depends on the size of the transaction and the maturity date.Another difficulty is that the interest rate on the current account is variable over time, as is the yield on treasury bills, which additionally depends on the maturity of separate series. When planning the optimal level of financial resources, the Baumol Model is a helpful tool, but it has many limitations that reduce its usefulness. The model is based on assumptions that are not realistic for the company, therefore it is not used in the work.

The Miller-Orr cash management model The Miller-Orr model is used for setting the target cash balance for a company. The diagram below shows how the model works over time.  

The model sets higher and lower control limits, H and L, respectively, and a target cash balance, Z. When the cash balance reaches H, then (H-Z) dollars are transferred from cash to marketable securities, i.e. the firm buys (H-Z) dollars of securities.



Similarly when the cash balance hits L, then (Z-L) dollars are transferred from marketable securities to cash.

The lower limit, L is set by management depending upon how much risk of a cash shortfall the firm is willing to accept, and this, in turn, depends both on access to borrowings and on the consequences of a cash shortfall. The formulae for the Miller-Orr model are: Return point = Lower limit + (1/3 × spread) Spread = 3 [ (3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3 Note: variance and interest rates should be expressed in daily terms. Variance = standard deviation squared.

Example using the Miller-Orr model The minimum cash balance of $20,000 is required at Miller-Orr Co,and transferring money to or from the bank costs $50 per transaction. Inspection of daily cash flows over the past year suggests that the standard deviation is $3,000 per day, and hence the variance (standard deviation squared) is $9 million. The interest rate is 0.03% per day.

Calculate: (i)the spread between the upper and lower limits (ii) the upper limit

(iii)the return point.

Solution: (i)Spread = 3 (3/4 × 50× 9,000,000/0.0003)1/3 = $31,200 (ii) Upper limit = 20,000 + 31,200 = $51,200 (iii)Return point = 20,000 + 31,200/3 = $30,400

Lockbox system A lockbox collection system allows companies to quickly process payments from customers. Customers send payments to one or more post office lockboxes. A bank employee collects the payments, deposits them into the company’s account and sends a report to the company. Whether or not you should use a lockbox system depends in part on whether the advantages of such a system outweigh the disadvantages of this method of collecting payments.

Advantages A lockbox system speeds up processing time for your payments. Instead of checks sitting in your office while an employee matches the payment to a bill and logs the payment into your system, then takes the payments to the bank, the payments go directly to the bank. Your employees post the checks after the fact, based on the reports you receive from the bank. Your money is available for your use more quickly. Companies that have branches in different parts of the country may set up lockboxes near those branches. Depending on where they’re located, customers send payments to the closest lockbox. This shortens mailing time and further speeds up access to funds for the company.

Disadvantages You’ll pay for the lockbox service, usually on a per-payment basis. If you receive a high volume of small payments, the cost of lockbox banking could quickly outweigh any advantages. Lockboxes are only as secure as the employees in charge of collecting payments from the boxes. These clerical employees may be among the least senior at the bank and susceptible to bribery. In one instance, investigator Stephen G. Korinko with Stroz Friedberg uncovered the theft of $11 million from a large bank’s lockbox service.

Deciding Lockboxes work best for companies that receive large payments from customers, such as mortgage firms, but utility companies and others who receive smaller payments also successfully use them. Different banks also charge differently for the service. Compare the cost of using your bank’s lockbox to the interest you’ll earn by having payments in your account one, two or more days earlier. A study of the time it takes you to process payments in-house will help you to accurately estimate the money you’ll gain from earlier deposits. Lockbox systems also work well if you have several branches of your business in different locations, or if you have a number of customers in one distant location. Putting a lockbox nearest your customers can reduce the time it takes for their payments to reach you.

Other Considerations Banks may be willing to negotiate the price for a lockbox service as a way of gaining your business. You should also investigate the bank’s security precautions to guard against theft and fraud. You’ll need to train your employees on posting payments under the new system, and make sure you communicate the new payment address to your customers, and arrange to forward any payments sent to the old address....