Page 259 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes P = Fixed cost for transaction
S = Opportunity cost of one rupee p.a.
Illustration: A firm maintains a separate account for cash disbursement. Total disbursement is
105,000 per month or 12,60,000 per year. Administrative and transaction cost of transferring
cash to disbursement account is 20 per transfer. Marketable securities yield is 8% p.a. Determine
the optimum cash balance as per J. Baumol's Model
Solution: The optimum cash balance

C =

= 25,100

11.5.2 Miller-Orr Cash Management Model

According to this model, the net cash flow is completely stochastic. When changes in cash
balance occur randomly the application of control theory serves a useful purpose.
The Miller-Orr model is one of such control limit models. This model is designed to determine
the time and size of transfers between an investment account and cash account. In this model,
limits are set for cash balances. These limits may consist of h as upper limit, z as the return point
and zero as the lower limit. When the cash balance reaches the upper limit, the transfer of cash
equal to h is invested in marketable securities account. When it touches the lower limit, a
transfer from marketable securities account to cash account is made. During the period when
cash balance stays between (h,z) and (z,o) i.e., high and low limits of cash balance are set up on
the basis of fixed cost associated with the securities transactions, the opportunity cost of holding
cash and the degree of likely fluctuations in cash balances. These limits satisfy the demands for
cash at the lowest possible total costs. The following diagram illustrates the Miller-Orr Model.

Figure 11.2: Miller-orr Cash Management Model

H

Z
Return Point

O Time

Self Assessment

Fill in the blanks:

9. The …………….. costs refer to the cost of holding cash.
10. The …………….. costs refer to the cost involved in setting the marketable securities
converted into cash.

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