Advantages Of Baumol Model Of Cash Management

DETERMINING CASH NEED:

There are two approaches to derive optimal cash equilibrium, i.e, Minimizing cost cash models Cash budget

CASH MANAGEMENT MODEL:

A number of mathematical model have been to develop to determine the optimal cash balance. Two of such models are as follows: William J. Baumol’s inventory model Miller and Orr’s model

Baumol model of cash management

Baumol model of cash management helps in determining a firm’s optimum cash balance under certainty. It is a model that provides for cost efficient transactional balances and assumes that the demand for cash can be predicted with certainty and determines the optimal conversion size or lot. It is extensively used and highly useful for the purpose of cash controlling. As per

The entire opportunity cost is the interest rate times the average cash balance kept by the firm.

Average lost opportunity cost = C/2 Relevance

Now a day many companies make an effort to reduce the costs incurred by preserving cash. They also attempt to spend a smaller amount on changing marketable securities to cash. The Baumol model of cash management is beneficial in this regard.

Use of Baumol Model

The Baumol model enables companies to find out their desirable level of cash balance under certainty. And this theory relies on the tradeoff between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one’s assets in the form of non-interest bearing cash. The main variables of the demand for cash are then the nominal interest rate, the level of actual income which resembles to the amount of desired transaction and to a fixed cost of transferring one’s wealth between liquid money and interest bearing assets.

Evaluation of the model Useful in determining optimal level of cash

They are: Upper Control Limit Lower Control Limit

The companies buy or sell marketable securities only if the cash balance is equal to any one of these. Once the cash balances of a business reaches the upper limit it purchases a certain number of saleable securities that helps them to come back to the desired level.

If the cash balance of the company reaches the lower limit then the company trades its saleable securities and gathers enough cash to fix the problem. It is normally assumed in such cases that the average value of the sharing of net cash flows is zero. Similarly, it is understood that the sharing of net cash flows has a risk. The Miller and Orr model of cash management also assumes that distribution of cash flow is normal.

Computation of miller and Orr model of Cash Management

Spread (Z) = (3/4*(Transaction cost*Variance of Cash flow) ⅓)/(Interest Rate) Return Point = Lower limit + (Spread (z))/3

Variance of Cash flow = (Standard Deviation) ² or (σ)