B. K.

SCHOOL OF MANAGMENT

Cash Management Models

By : -

Nishant Pare Prakash Shukla

1

Management Models
Baumols EOQ model Miller-Orr model

The Baumol Model

F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed K = The opportunity cost of holding cash: this is the interest rate. If we start with $C, spend at a constant rate each period and C replace our cash with $C when we run out of cash, our average cash C balanceC will be . 2 2 The opportunity C C cost of holding K Tim 1 2 3 2 is 2 e

F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed K = The opportunity cost of holding cash: this is the interest rate. As we transfer $C each period we incur a trading cost of F each period. If C we need T in total over the planning period we will pay $F, T C times. C
2

Tim e

T The trading cost is F C

F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed K = The opportunity cost of holding cash: this is the interest rate. As we transfer $C each period we incur a trading cost of F each period. If C we need T in total over the planning period we will pay $F, T C times. C
2

Tim e

T The trading cost is F C

The Baumol Model

C T Total cost K F 2 C
Opportunity Costs

C K 2

T Trading F costs C C* Size of cash balance The optimal cash balance is found where the opportunity costs equal the trading costs
2T C F K
*

The optimal cash balance is found where the opportunity costs equal the trading costs

C T K F 2 C

Opportunity Costs = Trading Costs

Multiply both sides by C

C2 K T F 2
2TF C K
*

T F C 2 K
2

Example The management of Popular Traders anticipates Rs 15 lakh in cash outlays (demand) during the next year. The recent experience has been that it costs Rs 30 to convert marketable securities to cash and vice versa. The marketable securities currently earns 8 per cent annual return. Find the total cost of managing cash according to Banmol model. Solution
Economic/o ptimal conversion size/lot 2 Rs 30 Rs 15,00,000 Rs 33,541 0.08

Number of conversions = Rs 15,00,000 Rs 33,541 = 45 Average cash balance = Rs 16,770.50 (Rs 33,541 2) Total cost = (Rs 30 45) + (0.08 Rs 16,770.50) = Rs 2,692

14-8

The Miller - Orr Model

The Miller-Orr Model provides a formula for

determining the optimum cash balance (Z), the point at which to sell securities to raise cash (lower limit L) and when to invest excess cash by buying securities and lowering cash holdings (upper limit H). Depends on: transaction costs of buying or selling securities variability of daily cash (incorporates uncertainty) return on short-term investments

The Miller - Orr Model

Upper Limit Buy Securities

Z
Lower Limit

L
Sell Securities Days of the Month

The Miller-Orr Model - Target Cash Balance (Z)

3

Z=

3 x TC x V +L 4xr

where: TC = transaction cost of buying or selling securities V = variance of daily cash flows r = daily return on short-term investments L = minimum cash requirement

The Miller-Orr Model - Target Cash Balance (Z)

Example: Suppose that short-term securities yield 5% per year and it costs the organization

$50 each time it buys or sells securities (TC). The daily variance of cash flows is $1000 (V) and your bank requires $1,000 minimum checking account balance (L).*
3

Z=

3 x 50 x 1000 4 x .05/360

+ $1,000

= $3,000 + $1,000 = $4,000

The Miller-Orr Model - Upper Limit

The upper limit for the cash account (H) is determined

by the equation: H = 3Z - 2L where: Z = Target cash balance L = Lower limit In the previous example: H = 3 ($4,000) - 2($1,000) = $10,000

To use the Miller-Orr model, the manager must do four things:

Set the lower control limit for the cash balance. Estimate the standard deviation of daily cash flows. 3. Determine the interest rate. 4. Estimate the trading costs of buying and selling securities.
1. 2.

The model clarifies the issues of cash management:

The best return point, Z, is positively related to trading costs, F, and negatively related to the interest rate K. Z and the average cash balance are positively related to the variability of cash flows.

To use the Miller-Orr model, the manager must do four things:

Set the lower control limit for the cash balance. Estimate the standard deviation of daily cash flows. 3. Determine the interest rate. 4. Estimate the trading costs of buying and selling securities.
1. 2.

The model clarifies the issues of cash management:

The best return point, Z, is positively related to trading costs, F, and negatively related to the interest rate K. Z and the average cash balance are positively related to the variability of cash flows.

Other Factors Influencing the Target Cash Balance

Borrowing Borrowing is likely to be more expensive than selling marketable securities. The need to borrow will depend on managements desire to hold low cash balances. Relative costs For large firms, the trading costs of buying and selling securities are very small when compared to the opportunity costs of holding cash.

17