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Cash Management Models
Cash Management Models
Cash Management Models
In the model, the carrying cost of holding cash-namely the interest forgone on marketable
securities is balanced against the fixed cost of transferring marketable securities to cash, or vice-
versa. The Baumol model finds a correct balance by combining holding cost and transaction costs,
so as to minimize the total cost of holding cash.
Where,
I = Interest on marketable securities p.a. (i.e., carrying cost per rupee of cash)
According to the model, optimum cash level is that level of cash where the carrying costs and
transaction costs are the minimum. The carrying costs refers to the cost of holding cash i.e.
interest forgone on marketable securities. The transaction cost refers to the cost involved in
getting the marketable securities converted into cash and vice versa.
Assumptions:
The Baumol’s model holds good if the following assumptions are fulfilled:
(a) The rate of cash usage is constant and known with certainty. The model has limited use in
times of uncertainty and firms whose cash flows are discontinuous or bumpy.
(b) The surplus cash is invested into marketable securities and those securities are again disposed
of to convert them again into cash. Such purchase and sale transactions involve certain costs like
clerical, brokerage, registration and other costs. The cost to be incurred for each such transaction
is assumed to be constant/fixed. In practice, it would be difficult to calculate the exact transaction
cost.
(c) By holding cash balance, the firm is would incur the opportunity cost of interest forgone by not
investing in marketable securities. Such holding cost per annum is assumed to be constant.
(d) The short-term marketable securities can be freely bought and sold. Existence of free market
for marketable securities is a prerequisite of the Baumol model.
Limitations:
The important limitations in Baumol’s model are as follows:
(i) The model can be applied only when the payments position can be reasonably assessed.
(iii) The model merely suggests only the optimal balance under a set of assumptions. But in actual
situation it may not hold good.
Nevertheless it does offer a conceptual framework and can be used with caution as a benchmark.
Illustration 1:
The outgoings of Gemini Ltd. are estimated to be Rs. 5,00,000 per annum, spread evenly
throughout the year. The money on deposit earns 12% p.a. more than money in a current account.
The switching costs per transaction is Rs. 150. Calculate the optimum amount to be transferred.
Solution:
According to Baumol, the optimum amount to be transferred each time is
ascertained as follows:
Where,
C = Optimum transaction size
Average balance in the short notice account = Rs. 35,000/2 = Rs. 17,500
Illustration 2:
ABC Ltd. has estimated that use of Rs. 24 lakhs of cash during the next budgeted year. It intends
to hold cash in a commercial bank which pay interest @ 10% p.a. For each withdrawal, the
company incurs expenditure of Rs. 150. What is the optimal size for each withdrawal?
Solution:
Each time the firm will withdraw Rs. 85,000 from the bank deposit. After spending all the
amount of Rs. 85,000, again the company will withdraw a similar amount and so on.
Illustration 3:
Tarus Ltd. has an estimated cash payments of Rs. 8,00,000 for a one month period and the
payments are expected to steady over the period. The fixed cost per transaction is Rs. 250 and the
interest rate on marketable securities is 12% p.a. Calculate the optimum transaction size.
Solution:
The optimum transaction size will be calculated as under:
Where,
I = Interest per annum i.e. 12% p.a. (For one month, the rate of interest is 196 or 0.01)
The model asserts that transfer money into or out of the account to return the balance to a
predetermined ‘normal point whenever the actual balance went outside a lower or upper limit.
The lower limit would be set by management, and the upper limit and return points by way of
formulae which assume that cash inflows and outflows are random, their dispersion usually being
assumed to repeat a pattern exhibited in the past.
0 = Lower control limit, sets the lower limit of cash balance, i.e. the firm should maintain cash
resources atleast to the extent of lower limit.
(ii) Then the new cash balance is z.(iii) When cash balance touches lower control limit (o),
marketable securities to the extent of Rs. (z-o) will be sold.
(b) The optimal values of ‘h’ and ‘z’ depend not only on opportunity costs, but also on the degree
of likely fluctuations in cash balances.
The model can be used in times of uncertainty and random cash flows. It is based on the principle
that control limits can be set which when reached trigger off a transaction. The control limits are
based on the day-to-day variability in cash flows and the fixed costs of buying and selling
government securities.
The higher the variability in cash flows and transaction cost, the wider and higher the control
limits will be. Conversely, the higher the interest rate, the lower and closer they will become.
Within the control limits, the cash balance fluctuates unpredictably.
When it hits an upper or lower limit, action is taken by buying or selling securities to restore the
balance to its normal level within the control points. In applying the model one must set the lower
limit for the cash balance. This could be zero or some minimum safety margin above zero.
Illustration 5:
Solution:
Illustration 6:
Interest rate per day/annum = 0.3%/10.95%
Therefore the upper limit is equal to the lower limit of Rs. 20,000 plus the spread of a Rs. 23,000
i.e., Rs. 43,000.
The return point is equal to the lower limit of Rs. 20,000 plus the spread of Rs. 23,000/3 i.e., Rs.
20,000 + Rs. 23,000/3 = Rs. 27,667.
Therefore, the firm’s cash management policy should be based on lower and upper control limits
of Rs. 20,000 and Rs. 43,000 respectively and the need to initiate action to keep will arise if it
move outside this band.