CASH MANAGEMENT- MODELS

While it is true that financial managers need not necessarily follow

cash management models exactly but a familiarity with them provides
and insight into the normative framework as to how cash management has
to be conducted. There are three analytical models which helps in
effective cash management.

• Baumol model
• Miller-orr model
• Orgler’s model

Baumol model:
The purpose of this model is to determine minimum cost amount of
cash that a financial manager can obtain by converting securities to
cash, considering the cost of conversion and the counter-balancing
cost of keeping idle cash balances which otherwise have been invested
in the marketable securities. The total cost associated with cash
management, according to this model, has two elements:
1. Cost of converting marketable securities into cash
2. The lost opportunity
The conversion cost is incurred each time marketable securities are
converted into cash. Symbolically,

TOTAL CONVERSION COST PER PERIOD = Tb/C

Where : b = cost of conversion which is assumed to be independent of
Of size of transaction
T = Total transaction cash needs for the period
 C = Value of marketable securities sold at each conversion.

The opportunity cost is derived from the lost/forfeited interest rate

(i) that could have been earned on the investment of the cash balances.
The total opportunity cost is the interest rate times the average cash
balance kept by the firm. The model assumes a constant and certain
pattern of cash outflows. At the beginning of each period, the firm
starts with a cash balance which it gradually spends until at the end of
the period it has a zero cash balance and must replenish its each supply
to the level of cash balance in the beginning. Symbolically, the
average lost opportunity cost.

i(C/2)
Where i = interest rate that could have been earned
c/2 = the average cash balance , that is the beginning
cash (C) plus the ending cash balance of the
period (0) divided by 2

The total cost associated with the cash management

comprising total conversion cost plus opportunity cost of not
investing cash until needed in interest- bearing instruments
can be symbolically expressed as:

I(C/2)+(Tb/C)

To minimise the cost, the model attempts to determine the

optimal conversion amount , that is, cash withdrawal that
costs the least. The reason is that the firm should not keep the
total beginning cash balance during the entire period as it is
not needed at the beginning of the period. For ex: if the
period were one thirty day month, only one-thirtieth of the
opening cash balance each day will be required. This means
only required one-thirtieth money is withdrawn and the rest
of the money will be invested in the marketable securities.

Miller-Orr Model:

The objective of cash management, according to miller-orr

(MO) is to determine the optimum cash balance level which minimises
the cost of cash management. Symbolically

C = bE (N) /t + iE (M)

b = the fixed cost per conversion

E(M) = the expected no. of conversions
t = the no. of days in the period
i = the lost opportunity cost
C = total cash management cost

The MO model is to make the baumol model more realistic as

regards the flow of cash. As against the assumption of uniform and
certain levels of cash balances in the baumol model, the MO model
assumes that cash balances randomly fluctuate between an upper
bound, the firm has too much cash balances back to the optimal bound
(z). when the cash balance hit zero, the financial manager must return
them to the optimum bound (z) by selling/converting securities into
cash. According to the MO model, as in Baumol model, the optimal
cash balance (z) can be expressed symbolically as

3br 2
z= 4i

r2 = the variance of the daily changes in cash balances

Thus, in the baumols model there are economies of scale is cash
management and the two basic cost of conversion and lost interest that
have to be minimised.

Orgler’s Model:
According to this model, an option cash management strategy
can be determined through the use of multiple linear programming
model. The construction of the model comprises three section: (1)
selection of the appropriate planning horizon, (2) selection of the
appropriate decision variables and (3) formulation of the cash
management strategy itself. The advantage of linear programming
model is that it enables coordination of the optimal cash management
strategy with the other opertions of the firm such as production and
with less restrictions on working capital balances.

The model basically uses one year planning horizons with

twelve monthly periods because of its simplicity. It has four basic sets
of decisions variables which influence cash management of a firm and
which must be incorporated into the linear programming model of the
firm. These are;
 1. payment schedule
2. short-term financing
3. purchase and sale of marketable securities
4. cash balance itself

The formulation of the model requires that the financial managers

first specify an objective function and then specify a set of constraints.

Orgler’s objective function is to ‘ minimise the horizon value of the

net revenues from the cash budget over the entire planning period’. Using
the assumption that all revenues generated are immediately re-invested
and that any cost is immediately financed , the objective function
represents the value of the net income from the cash budget at the horizon
“ by adding the net returns ove the planning period”. Thus, the objective
function recognises each operations of the firm that generates cash
inflows or cash outflows as adding or subtracting profit opportunities
from the firm from its cash management operations.
An example for the linear programming model is as follows.

Objective function:
Maximise profit = a1 x1 + a 2 x2

The important feature of the model is that it allows the financial

managers to integrate cash management with production and other
aspects of the firm.