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Unit 7: Cash Management
The firm incurs a cost known as holding cost for maintaining the cash balance. It is known as Notes
opportunity cost, the return inevitable on the marketable securities. If the opportunity cost is k,
then the firm's holding cost for maintaining an average cash balance is as follows:
Holding Cost = k (C/2)
Whenever the firm converts its marketable securities to cash, it incurs a cost known as transaction
cost. Total number of transactions in a particular year will be total funds required (T), divided by
the cash balance (C) i.e. T/C. The assumption here is that the cost per transaction is constant. If
the cost per transaction 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 also increase and the transaction cost
will reduce because of a decline in the number of transactions. Hence, it can be said that there is
a relationship between the holding cost and the transaction cost.
The optimum cash balance, C* is obtained when the total cost is minimum.
Optimum cash balance (C*) = [2cT/k] ½
Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.
With the increase in the cost per transaction and total funds required, the optimum cash balance
will increase. However, with an increase in the opportunity cost, it will decrease.
Cost
Total cost
Holding cost
Transaction cost
Cash Balance
Miller-Orr Model
Most firms don’t use their cash flows uniformly and also cannot predict their daily cash inflows
and outflows. Miller-Orr Model helps them by allowing daily cash flow variation.
Under the model, the firm allows the cash balance to fluctuate between the upper control limit
and the lower control limit, making a purchase and sale of marketable securities only when one
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