Cash management Presentation Mangerial Finance.ppt

8/10/2019 Cash management Presentation Mangerial Finance.ppt

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Baumol Model

Miller Orr Model

Baumol Model

Most firms try to minimise the sum of the cost of holdingcash and the cost of converting marketable securities to

cash.This Model based on the minimisation of 2 costs.Carrying cost:Transaction Cost:

As per this model that amount of cash both in hand &marketable securites is the optimum where total of these 2costs in miminmum.


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Trades off between opportunity cost orcarrying cost or holding cost & the transactioncost. As such firm attempts to minimize the

sum of the holding cash & the cost ofconverting marketable securities in to cash.

Helps in determining a firm's optimum cashbalance under certainty


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Assumptions:

1. The firm is able to forecast its cash requirements withcertainty and receive a specific amount at regular intervals.2. The firms cash payments occur uniformly over a period of

time i.e. a steady rate of cash outflows.3. The opportunity cost of holding cash is known and does notchange over time. Cash holdings incur an opportunity cost inthe form of opportunity foregone.

4. The firm will incur the same transaction cost whenever itconverts securities to cash. Each transaction incurs a fixed andvariable cost.


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For example, let us assume that the firm sellssecurities and starts with a cash balance of Crupees. When the firm spends cash, its cash balancestarts decreasing and reaches zero. The firm againgets back its money by selling marketable securities.As the cash balance decreases gradually, theaverage cash balance will be: C/2. This can beshown in following figure:

The firm incurs a cost known as holding cost for maintainingthe cash balance. It is known as opportunity cost, the return

inevitable on the marketable securities. If the opportunitycost is k, then the firms holding cost for maintaining anaverage cash balance is as follows:


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Holding cost = k (C/2)Whenever the firm converts its marketable securities to cash, itincurs a cost known as transaction cost. Total number oftransactions in a particular year will be total funds required (T),

divided by the cash balance (C) i.e. T/C. The assumption here isthat the cost per transaction is constant. If the cost pertransaction is c, then the total transaction cost will be:

Transaction cost = c (T/C)

The total annual cost of the demand for cash will be:

Total cost = k (C/2) + c (T/C)

Optimum level of cash balance

As the demand for cash, C increases, the holding cost will alsoincrease and the transaction cost will reduce because of a declinein the number of transactions. Hence, it can be said that there isa relationship between the holding cost and the transaction cost.

The optimum cash balance, C* is obtained when the total cost isminimum.


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Optimum cash balance (C*) = 2cT/kWhere, C* is the optimum cash balance.T is the total cash needed during the year.k is the opportunity cost of holding cashbalances.

With the increase in the cost per transaction and

total funds required, the optimum cash balancewill increase. However, with an increase in theopportunity cost, it will decrease.


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Evaluation of the model

Helpful in determining optimum level ofCash holdingFacilitates the finance manager to minimize

Carrying cost and Maintain CashIndicates idle cash Balance Gainfulemployment

Applicable only in a situation of certainty inother words this model is deterministic model


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1. It does not allow cash flows to fluctuate.

2. Overdraft is not considered.

3. There are uncertainties in the pattern offuture cash flows. Because CFs are

expected in future.


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The Miller and Orr model of cashmanagement is one of the most

important cash management models. Ithelps the present day companies tomanage their cash while taking into

considerations the fluctuation in dailycash flows.


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Cash management Presentation Mangerial Finance.ppt

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