Page 119 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes The Baumol Model

The Baumol model of cash management is one of many by which cash is managed by companies.
It is extensively used and highly useful for the purpose of cash management. The model enables
companies to find out their desirable level of cash balance under certainty.
At present many companies make an effort to reduce the costs incurred by owning cash. They
also strive to spend less money on changing marketable securities to cash. The Baumol model of
cash management is useful in this regard.

Assumptions

There are certain assumptions or ideas that are critical with respect to the Baumol model of cash
management:
1. The particular company should be able to change the securities that they own into cash,
keeping the cost of transaction the same. Under normal circumstances, all such deals have
variable costs and fixed costs.
2. The company is capable of predicting its cash necessities. They should be able to do this
with a level of certainty. The company should also get a fixed amount of money. They
should be getting this money at regular intervals.
3. The company is aware of the opportunity cost required for holding cash. It should stay the
same for a considerable length of time.
4. The company should be making its cash payments at a consistent rate over a certain period
of time. In other words, the rate of cash outflow should be regular.
Equational Representations in Baumol Model of Cash Management

1. Holding Cost = k(C/2)
2. Total Cost = k(C/2) + c(T/C)
3. Transaction Cost = c(T/C)
Limitations

1. Cash flows may not be very predictable, much less constant
2. Treasurers may want a ‘safety stock’ of cash
For example, let us assume that the firm sells securities and starts with a cash balance of C
rupees. When the firm spends cash, its cash balance starts decreasing and reaches zero. The firm
again gets back its money by selling marketable securities. As the cash balance decreases
gradually, the average cash balance will be: C/2. This can be shown in following figure:

Average

Time

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