Page 282 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Self Assessment

Fill in the blanks:
7. The financial manager’s concern is with the available balance and not with the company’s
……………balance

8. One can increase the available cash balance by increasing the……………...

13.3 Cash Management Models

In recent years, several types of mathematics models have been developed that help to determine
optimum cash balance to be carried by a business organization. All these models can be put into
two categories – inventory type models and stochastic models. Inventory type models have
been constructed to aid the finance manager to determine optimum cash balance of the firm.
However, in a situation where EOQ Model is not applicable, the stochastic model of cash
management helps in determining optimum level of cash balance. It happens when the demand
for cash is stochastic and is not known in advance.

13.3.1 William J Baumol’s Economic Order Quantity Model

According to this model, optimum cash level is that level of cash where the carrying costs and
transaction costs are the maximum. The carrying costs refer to the cost of holding cash, namely
the interest foregone in marketable securities. The transaction costs refer to the cost involved in
setting the marketable securities converted into cash. This happens when the firm falls short of
cash and has to sell the securities resulting in clerical, brokerage, registration and other costs.
The optimum cash balance will be that point where these two costs are equal. The formula for
determining optimum cash balance is:
2 U × P
C =
S
Where, C = Optimum cash balance
U = Annual (or monthly) cash disbursement
P = Fixed cost for transaction
S = Opportunity cost of one rupee p.a.

Example: 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. Baumal’s Model
Solution: The optimum cash balance

2 × 12,60,000 × 20
C =
0.8
= 25,100

13.3.2 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 –

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