Cash

Management
Models
PRESENTATION BY- RAKSHIT CHA UHAN
(1619) AND TU SHA R BA RNAWAR (1517)
Optimum Cash Balance
The cash budget for a firm may indicate the period when it is expected to have a shortage or surplus of
funds. If a shortage is expected, ways and means of over coming it must be thought of; and in case of
expected surplus, its profitable usage in marketable securities should be explored.

However, before converting cash into marketable securities and vice versa, the financial manager must
determine and assess the optimum cash balance for the firm. He should also find out when and how
much cash is to be converted.

The problem of determining optimum cash balance for a firm in fact, implies a trade-off between risk
and return of maintaining cash balance.
Baumol’s Model
Suggested by W.J. Baumol in 1952.

Same as the Economic Order Quantity Model of Inventory management.

This model attempts to balance the income foregone on cash held by the firm against the transaction
cost of converting cash into marketable securities or vice versa.
It assumes that the firm uses cash at an already known rate period and that this rate of use is constant.

The optimum cash balance is found by controlling the holding cost and transaction cost so as to
minimize the total cost of holding cash.
Explanation
This model can be presented as follow:

where, C = Cash required each time to restore balance to minimum cash

F = Total cash required during the year

T = Cost of each transaction between cash and marketable securities

r = Rate of interest on marketable securities.

Determination of Optimum Cash
Balance
As per Baumol’s Model, the firm should start each Total cost

period with the cash balance equaling ‘C’ and Holding cost

Cost
spend gradually until its balance comes to zero.
At this time, the firm should replenish the cash
equaling ‘C’ from the sale of marketable securities.

Transaction cost

Cash Balance Optimum Cash Balance Cash Balance

Limitations
The model assumes a constant rate of use of cash. The cash outflows in any firm are not regular and
hence this model may not give correct results.

The transaction cost will also be difficult to be measured since these depend upon the type of
investment as well as the maturity period.
Miller-Orr Model
Given by Miller and Orr in 1966.

Expanded the Baumol’s model which is not applicable if the demand for cash is not steady.

The Miller-Orr model argues that changes in cash balance over a given period are random in size as
well as in direction.
The model assumes:
Out of the two assets i.e., cash and marketable securities, the latter has a marginal yield, and
Transfer of cash to marketable securities and vice-a-versa is possible without any delay but of course of
at some cost.
Explanation
The model may be defined as follow:
Z=
where, T = Transaction Cost of conversion
V = Variance of daily Cash flows, and
i = Daily % interest on interest rate on investments.
Determination of Optimum Cash
Balance
The model has specified two control limits for cash balance.
An upper limit, H, beyond which cash balance need not be allowed to go and a lower limit, L, below
which the cash level is not allowed to reduce.
The cash balance should be allowed to move within these limits.
Which is better?
The Miller-Orr model has a superiority over the Baumol’s model.

 The Baumol’s model assumes constant need and constant rate of use of funds, the Miller-Orr model,
on the other hand, is more realistic and maintains that the actual cash balance may fluctuate between
the higher and the lower limits.
Thank you